Contracts such as Miami and Baltimore (and others) have been repeatedly announced, then quietly cancelled, re-announced, but then quietly cancelled again.

Note: This article is the opinion of the author. The author is short SSTI.

I suspect that much of the information in this article may actually come as a surprise even to certain board members. ShotSpotter has historically provided very optimistic reports to its board members, touting the unmitigated success and “proof” of its products, without including information like I have included below. A copy of one of these reports is included below.

Note:Share count of 11.69 million shares includes 2.05 million shares underlying deep in the money warrants and options with an average strike price of $4.55. Sell side analysts continue to ignore these 2.05 million shares.

ShotSpotter Inc. (SSTI) offers software and hardware systems which provide locational information on gunshot activity within covered areas. When someone fires a gun, ShotSpotter’s microphones detect the gunshot and send the data to a ShotSpotter center in California. It is then determined if it is indeed a gunshot. Finally, the location of the gunshot is relayed to law enforcement personnel.

*** SHOT SPOTTER INVESTMENT THESIS – SUMMARY

Below I will make clear the following points to show why ShotSpotter will quickly fall by around 80% to $2-4, once the lockup expires on December 4th.

Uninterrupted history of failure. After a 23 year history of uninterrupted commercial and financial failure, ShotSpotter was suddenly publicly hyped in 2017 as an innovative high tech solution to gun violence, so that it could come public in an IPO by Roth Capital. For two decades ShotSpotter has had repeated brushes with outright insolvency.

The IPO was arranged as the only exit for insiders from a business that has been unable to succeed for more than 20 years. The purpose of this IPO was simply to allow insiders and PE investors to exit an otherwise unsellable, money losing investment. On December 4th, 8 million shares will be released from lockup, allowing these investors to finally sell. Ahead of that lockup expiration, ShotSpotter juiced its revenues by pulling forward nearly$1 million of revenues from a cancelled Puerto Rico contract and then failing to disclose other contract cancellations.

ShotSpotter. Does. Not. Work. Period. Reams of hard data prove quite conclusively that ShotSpotter simply does not work. This is why ShotSpotter has repeatedly been unable to maintain customers or generate any profits despite 20 years of trying. Actual documented success rates of less than 2%, with 70-80% of all alerts being unfounded or false alarms.

Customers explicitly state that ShotSpotter does not work and fully confirm the hard data. New customers keep canceling. Following their cancellations, former customers confirm categorically that ShotSpotter simply does not work. Including major “trophy” contracts such as Baltimore, Miami, San Antonio and Oakland.

ShotSpotter employee testimony (under oath) states that data presented to law enforcement is outright fabricated.

Aggressive tactics to conceal, distort or prevent outright the release of the “damning” data. Internal memos reveal aggressive tactics by ShotSpotter to thwart FOIA requests by journalists and universities seeking transparency into government spending on ShotSpotter. Deliberate steps to legally gag police forces from disclosing the negative data. The data being withheld is the same data that categorically proves that ShotSpotter simply does not work.

ShotSpotter fails to disclose major contract losses ahead of lockup expiration. In its November earnings call, ShotSpotter indicated clearly that only one contract had been lost. Below I show the proof that 3 more contracts have been lost but not disclosed by ShotSpotter ahead of the lockup expiration.

ShotSpotter makes diametrically opposing statements to law enforcement, journalists and university researchers, depending on its financial interest in each situation. ShotSpotter presents one set of facts to law enforcement when selling its product to government payers. It then presents the opposite “facts” to parties trying to investigate spending on ShotSpotter and its effectiveness. ShotSpotter also presents additional “facts” which contradict its own data when marketing the product. The government payers who buy ShotSpotter are relying on the wrong data.

*** SECTION 1 – OVER 20 YEARS OF UNINTERRUPTED FAILURE AND LOSSES

ShotSpotter’s technology is not new. Neither is gun violence.

ShotSpotter’s founder, Robert Showen came up with this idea all the way back in 1994 when he kept hearing the sounds of gunfire in neighboring East Palo Alto. Over the years, there have been a few minor improvements to the technology to try to weed out more false positives (from other loud noises). But overall, the technology is still largely the same as it was 23 years ago.

Recent media headlines have been dominated by gun violence. But in fact, the US has had an epidemic problem of gun violence for decades. Despite this decades of ongoing violence, ShotSpotter has not been able to achieve any real traction, and certainly no profits for more than 20 years.

Here is a list of gun violence incidents that made major US headlines, all in 2015 or earlier. The point is that high profile gun violence has been a problem in the US for decades, yet it has not allowed ShotSpotter to ever generate a profit.

Date

Incident

Date

Incident

12/2/2015

San Bernardino Attack – 14 killed

11/5/2009

2009 Fort Hood Shooting – 13 killed

10/1/2015

Umpqua Community College Shooting – 9 killed

4/3/2009

Binghamton Shootings – 13 killed

6/17/2015

Charleston Church Shooting – 9 killed

4/16/2007

Virginia Tech Massacre – 32 killed

9/16/2013

Washington Navy Yard Shooting – 12 killed

4/20/1999

Columbine High School Massacre – 13 killed

12/14/2012

Sandy Hook Elementary School Shooting – 27 killed

10/16/1991

Luby’s Shooting – 23 killed

7/20/2012

Aurora Movie Theater Shooting – 12 killed

8/20/1986

Edmond Post Office Shooting – 14 killed

1/8/2011

2011 Tucson Shooting – 6 killed

7/18/1984

San Ysidro McDonald’s Massacre – 21 killed

ShotSpotter has repeatedly been forced to raise new money via private placements in order stave off insolvency, with investors describing the company as “ subsisting on fumes”. At one point, ShotSpotter decided to change the direction of its business and attempt to create a“big data” play on its detection of gun shots. At the time, “big data” was the hot new thing.

That “big data” plan fizzled entirely. But the collection and analysis of the “big data” did have one result: there was now enough data gathered to prove categorically that ShotSpotter’s technology simply does not work.

This was obviously very, very bad. So ShotSpotter quickly adopted a campaign to thwart any release of that data, including blocking access for universities seeking to research it under the Freedom of Information Act.

With private equity no longer willing to fund it, in June of 2017, ShotSpotter decided to come public in an IPO led by Roth Capital.

Not surprisingly, the bankers behind the IPO are also the exact same banks who are pumping out bullish research on ShotSpotter. Roth Capital, Imperial Capital and Northland Capital.

When the lockup expires on December 4th, these are the same banks who will make millions of dollars in banking fees by running the secondary offering for the insiders to sell over 8 million shares.

Not surprisingly, each of these banks has been able to ignore the wealth of information that I present in this article. A large December fee event will no doubt provide a nice bump up in each of their year end bonuses. The support of these analysts therefore comes as no surprise.

Here is what we are hearing from Roth Capital, Imperial Capital and Northland Capital just ahead of this pending lockup expiration. So far they have made no mention of the concerns I raise below.

*** SECTION 3 – SHOTSPOTTER. DOES. NOT. WORK. PERIOD. (THE DATA)

The data against shot spotter is absolutely and overwhelmingly conclusive. And it comes in great detail from a wide variety of completely independent sources. Each of these point to the same exact results.

As I will show in a subsequent section, ShotSpotter has undertaken significant efforts to thwart the release of any performance data for its product. This is because the data is absolutely horrific. It proves conclusively that the product provides no material benefit whatsoever.

But an investigative journalist from Forbes was able to separately obtain and analyze much of the data behind ShotSpotter. His conclusions were beyond compelling.

The data obtained by Forbes in 2016 showed that ShotSpotter provided huge numbers of alerts to law enforcement, but that more than 98% of these alerts ended in no arrests being made.

Up to 70% of the alerts were described as entirely “unfounded”.

Roughly 90% of the time, no police report was ever even filed following the alert from ShotSpotter.

In trying to attract and retain customers, ShotSpotter repeatedly touts the high number of alerts that its system puts out, indicating that the higher the number of alerts, the greater the benefit it is providing

But as we will see below, the high alert rate itself is actually the biggest problem, because the overwhelming majority of ShotSpotter alerts are nothing more than false alarms.

The data above is the quantitative proof which ShotSpotter has been aggressively trying to suppress from public view. It is notable that the data are highly consistent across cities of all sizes and locations within the country.

In fact, additional qualitativeproof comes in the form of public statements from municipal officials and law enforcement who went on the record to publicly explain why they were abandoning this system after spending huge sums of tax payer money to have it installed.

Below I present the on-the-record comments made by law enforcement officials and government officials who have actually used and evaluated the ShotSpotter system.

What you should notice is this:

The comments below precisely echo the quantitative data above, even though they come from a wide range of totally different cities.

In addition, (just like the city data above), the verbal comments and complaints below are highly consistent among one another.

Once again, each of these cities says the exact same thing: that ShotSpotter simply doesn’t work.

The list of cities who have cancelled ShotSpotter and then publicly decried its total lack of effectiveness specifically includes cities such as Miami, Baltimore, San Antonio and Oakland. These cities have been repeatedly touted as being on the cusp of providing major revenues to ShotSpotter. But then the contracts with those cities have been cancelled or discontinued prematurely with little or no revenue at all.

#1 – Miami previously cancelled and said ShotSpotter doesn’t work

Recent headlines have indicated that ShotSpotter is on track to implement a major contract installation in Miami. ShotSpotter is a brand new IPO, so perhaps investors can be forgiven for not knowing the prior history of major contract announcements (specifically for Miami) which were then repeatedly cancelled with little or no revenue.

Local Miami media is already skeptical of the latest supposed Miami contract, because they have seen this gambit with ShotSpotter before.

Both the Miami Police Department and the Broward County Sheriffs Department have publicly gone on the record to state that ShotSpotter simply does not work. Worse than that, implementing the system results in a massive diversion of police resources to unfounded calls, taking officers away from actual crimes being committed.

This is why both the city and the county cancelled their previous contract. (Below we will see in greater detail the mechanics behind the repeated re-announcements of contracts that are then cancelled with little to no revenue).

In Miami, for every one verifiable gunshot, there were at least twenty false alarms. After more than a year, the system led to just four arrests.

They could chalk up only four arrests to the system compared to the many man hours wasted by deputies checking out false alarms.” Apparently, ShotSpotter could not distinguish between “gunshots, firecrackers, vehicle backfires or big trucks downshifting on nearby I-95.

#2 – Baltimore cancelled and said ShotSpotter doesn’t work

Just like Miami, we have seen multiple public announcements trumpeting a ShotSpotter contract for Baltimore. These reports were actually entirely wrong, but few people ever saw the quiet corrections down the road.

As with Miami, despite some flashy news in 2017, Baltimore had already tried, evaluated and then cancelled ShotSpotter on two separate prior occasions.

In February of 2014, SSTI posted to its web site a very prominent post highlighting that the Baltimore police department would be implementing ShotSpotter. This announcement was exceptionally high profile because by this time the gun violence crisis in Baltimore had already surpassed Chicago in severity.

It took until a full year later, but we finally found out that this post was not only grossly premature, but it also turned out to be completely wrong.In fact, a full year later we found that this contract never went in to place at all in 2014 and that it would not be doing so going forward. In other words, in 2014 this information was so preliminary that it should have never been posted by the company at all. And in the end it turned out to be just flat out wrong. The contract had never even happened in the first place a full year earlier.

We can see from Baltimore the consistent complaint from law enforcement. Not only does ShotSpotter not work, but implementing it actually causes even larger problems. As shown above, Baltimore stated that:

the fight against crime would be adversely affected by proceeding with the system.

expensive and redundant…They say residents already call to alert police when they hear gunfire, and the money could be better used to fund other technology, such as the police helicopter.

Keep in mind, that Oakland is right in the backyard of ShotSpotter and its founders.

As of recent quarters, Oakland was still a partial customer of ShotSpotter.

On the recent conference call on November 7th, ShotSpotter indicated clearly that aside from Puerto Rico/Virgin Islands, there had been no other contract losses.

But as far back as April 28, 2017 the city of Oakland had already publicly disclosed that it was discontinuing its expansion of ShotSpotter. Phase I had already been implemented, but Phases 2 and 3 have now been cancelled. As is always the case, the part actually implemented was small, while the majority of the previously announced contracts were actually cancelled without providing the “expected” revenue to ShotSpotter.

In fact, given the public statements to the press by Oakland police, these cancellations really should have come as no surprise whatsoever.

Clearly someone in the Oakland municipal government has a favorable opinion of ShotSpotter. But in fact, the police have actually been trying to scrap the program foryears – since 2014. In its attempts to keep Oakland from cancelling their entire program, ShotSpotter then slashed its fees dramatically.

As shown below, although ShotSpotter has publicly indicated that it hasn’t lost any major contracts other than Puerto Rico/Virgin Islands, the company’s San Antonio contract has already been lost in recent months.

In October 2016, SSTI announced that ShotSpotter was expanding into eight new areas, San Antonio being one of them.

The question is this: Did ShotSpotter lose the Fall River contract or not ?

On the one hand…it is true that Fall River continues to use the ShotSpotter product.

But on the other hand…after Fall River recently canceled their contract, ShotSpotter just now started providing Fall River with the service for FREE.

Clearly the contract that ShotSpotter had signed with Fall River required payment for the service and clearly those payments are no longer being made. In other words, “Yes”, the contract has been cancelled. But “No” the loss of this contract has not been announced by ShotSpotter. In fact, the data provided by ShotSpotter on November 7 th clearly indicated that aside from Puerto Rico/Virgin Islands, no other contracts had been lost.

For now, ShotSpotter has offered to continue to provide free service to Fall River such that it feels that it does not need to disclose the contract loss until after the lockup. Very convenient !

But here’s the rub: once the lockup expires on December 4 th SSTI will have no more reason to lose money by proving free service to non paying customers. I expect that at that time the cancellation of the contract will finally be announced.

Along with a 41 percent false alarm rate and an expensive price tag, Fall River police have reported that there have even instances where ShotSpotter failed to report gunshots in locations where the sensors were located.

According to the Troy police department, “The system was suppose to become attuned to the way sounds were heard in Troy’s streets and differentiate among the brakes of a truck climbing the Hoosic Street hill, from a firecracker, actual shots and any other noise.” These attributes were “never completely achieved.”

Some members of law enforcement are already catching on to ShotSpotter’s “marketing” ruses.

Last year, Memphis police deputy chief Jim Harvey posted on his LinkedIn page a request for feedback on ShotSpotter. Instead, he was inundated with feedback from various people with various direct and indirect ties to ShotSpotter itself

Internal memos from ShotSpotter reveal the aggressive tactics that ShotSpotter is using to thwart the release of data under FOIA

FOIA allows for several exceptions including for law enforcement, public safety, and trade secrets. In fact, the only “secret” that ShotSpotter is trying to protect is the fact that its product simply doesn’t work and that it is a waste of federal and local tax dollars.

In internal memos, ShotSpotter is not shy about saying that the purpose of withholding this information is to protect its own business from “harm” that would be caused by releasing the data.

ShotSpotter instructs recipients to:

#1 – simply refuse to release, or

#2 – release data that is heavily redacted to not show the terminal flaws shown above

#3 – “ Obscure” the most important information

And then even when any information is actually released, ShotSpotter has specifically instructed its recipients to deliberately provide only paper copies of the heavily redacted information so as to further thwart dissemination online by anyone.

The screenshot below is a “ Customer Success Training Bulletin” circulated by ShotSpotter.

Notably, ShotSpotter is more than happy to release data which simply shows the huge number of raw alerts. This information is then used for marketing purposes.

The grand irony here is that it is precisely this excessive number of false alerts that is precisely the reason why ShotSpotter is so ineffective and wasteful of public resources. But because ShotSpotter deliberately stymies the release of the full data set, this large number of alerts actually looks like a net positive for the system. As a result, no one is the wiser.

Below I show repeated examples where ShotSpotter actively promotes itself based on the notion that “a high number of alerts equals a higher level of public safety”.

Some of the data below has been released directly from ShotSpotter’s web site. Other material has then been re-disseminated through third party sites which quote the original data being put out by ShotSpotter.

“ Total Number of Published Gunfire Incidents: 74,916; Per Day: 205.2; Per Hour: 8.6”“ ShotSpotter’s coverage is most extensive in the eastern half of the city. By the quadrant, the network has captured 18,700 incidents in Southeast, 10,600 incidents in Northeast, 6,400 in Northwest and 1,600 in Southwest…The network has logged an additional 1,600 shootings along the edges of the city.”

“ In Q4 2014 there were 16,597 incidents in ShotSpotter coverage areas, and of those, 3,556 (or 21.4%) took place during the New Year’s Eve period.”“ In 2014 there were 33,975 separate gunfire incidents in the 47 cities measured. That translates to 105 gunfire incidents per day, or 4.4 incidents every hour – just in ShotSpotter-protected areas of the 47 cities.”

“ During the first half of 2014, SST reported 11,675 gunfire incidents occurred in the 107.6 square miles in those areas; down from 14,703 in the same period in 2013 over 98.6 square miles.”

Selling the board of directors:

These are the exact type of stats that ShotSpotter management feeds to its board members in periodic “progress reports”. The reports contain very brief “news” articles which read more like press releases and contain heavy amounts of data supplied directly by ShotSpotter itself. They also contain lengthy “ case studies” which were written by management to tout success stories. But in reading the “case studies” more closely, it becomes interesting to observe the large number of “satisfied customers” who then canceled their contracts subsequent to the date of the report.

The point is this: ShotSpotter actively promotes its product on the basis that “more alerts equates to greater public safety”. In fact, as we can see from the data and the customer complaints, the exact opposite is true. The biggest problem is that ShotSpotter results in false alerts as much as 70-90% of the time. But because ShotSpotter has largely concealed the data, the public and the government payers may not know until after they use and then cancel the system.

News of each of these contract cancellations occurred in time to be included in ShotSpotter’s November 2017 earnings release.

Despite this, ShotSpotter has not disclosed any of these cancellations.

In some cases, in response to cancellation, ShotSpotter has taken to “giving the service for free” to delay reporting the cancellation until after the lockup expires. But the fact is that such customers already announced their cancellation and are no longer paying ShotSpotter.

Also, keep in mind that these are just the ones I have already found. There may be additional undisclosed contract losses that I have not yet found. But I will continue looking, of course.

On the earnings call on November 7th, the comments made by CEO Ralph Clark made it very clear that aside from Puerto Rico/Virgin Islands, the company had not lost any other contracts.

Puerto Rico was important because it was ShotSpotter’s 2 nd largest customer accounting for 10% of revenues. It was a big loss, but at least it was (according to the CEO) the only loss.

CEO Clark stated that net new miles gone live in the quarter was only 17. The total gross new miles was 50. But Clark stated clearly that the number of square miles lost in Puerto Rico/Virgin Islands was exactly 33.

In other words, ahead of this key lockup, Mr. Clark has made it very clear that aside from Puerto Rico/Virgin Islands, ShotSpotter has not lost any other customers. This information has clearly provided strong support to the stock price just ahead of the lockup expiration where insiders can finally sell their shares.

Cancellation #1 – San Antonio. Newspaper articles from as far back as August 2017 were already noting that San Antonio was cancelling its contract. They were quite clear in stating their reasons why:

Specific quotes from San Antonio Police include:

about 80 percent of the times when ShotSpotter was activated, police could find no evidence of a shooting at the scene

the system only resulted in a mere 4 arrests – at a cost over $136,500 per arrest

Even though this cancellation (and the reasons why) could be found as early as 6 months ago, ShotSpotter has recently continued to insist that the only lost contract was Puerto Rico.

Cancellation #2 – Fall River.As we also saw above, Fall River, MA is no longer paying for the service, but ShotSpotter is continuing to provide the service for free so as to not disclose the loss of the contract ahead of the lockup expiration.

ShotSpotter has agreed to let the city of Fall River continue to use the system for free, Mayor Jasiel Correia announced Thursday.

Cancellation #3 – Oakland, CA

As far back as April 28, 2017 the city of Oakland had already publicly disclosed that it was discontinuing its expansion of ShotSpotter. Phase I had already been implemented, but Phases 2 and 3 have now been cancelled. As is always the case, the part actually implemented was small, while the majority of the previously announced contracts were actually cancelled without providing the “expected” revenue to ShotSpotter.

In fact, given the public statements to the press by Oakland police, these cancellations really should have come as no surprise whatsoever.

In fact, beyond this deliberate distortion of the data above, ShotSpotter goes much further in disseminating information that is flat out incorrect.

We can see repeated examples where ShotSpotter gives one set of facts to law enforcement customers but then gives contradicting “facts” to researchers and journalists who are investigating the use of ShotSpotter.

Here are 3 examples:

Example #1 – “Alternative facts” on crime data

Jennifer Doleac is an assistantprofessor of public policy and economics at the University of Virginia who attempted to get her hands on the data underlying ShotSpotter to assess whether it actually works and if it is a sensible use of tax dollars.

ShotSpotter adamantly rebuffed any and all efforts to obtain the data for analysis. When Ms. Doleac requested the information citing that the data was a matter of public interest – crime data – Mr. Clark sent her astrongly worded letter insisting that ShotSpotter was now a “Cloud based services model” and specifically that SST’s ShotSpotter data is NOT crime data”.

Obviously this statement from Clark defies common sense. We know that any data related to urban gunfire is going to be crime data.

This statement by ShotSpotter CEO was a convenient excuse for the company to suddenly refuse to release the data which would prove that the product is a waste of taxpayer dollars.

As shown in the examples below, ShotSpotter has consistently described its data as crime data when that served a useful marketing purpose. But when the release of “crime data” became a threat to ShotSpotter became a threat, the CEO simply changed his story.

The point is this: In trying to sell its product to government payers, ShotSpotter repeatedly highlights the value of its crime data. But as soon as it fears it will have to turn the data over to independent investigators in FOIA requests, ShotSpotter simply claims that this data is no longer “crime data”. ShotSpotter will say anything (even contradicting its own earlier statements) to prevent the release of the reams of data which prove that the product does not work.

Example #2 – Because ShotSpotter doesn’t work, the company invents new metrics in order to sell the product to new cities.

ShotSpotter clearly doesn’t work in even remotely the way it is marketed. We can see that from the raw data as well as the detailed comments from law enforcement across the country. We can also see it in various court documents and investigative articles.

We know from the data and complaints above that ShotSpotter doesn’t improve public safety or reduce gun violence. In the vast majority of cases, the system can’t even determine if any shot was fired at all.

So instead, ShotSpotter has taken to inventing new “success objectives” for the use of its product.

Even if there are no arrests or other public safety benefits, ShotSpotter tries to convince the public that there is some benefit to things like:

According to Forbes, ShotSpotter claims that there is a longer term benefit which (of course) is much harder to verify or quantify. As an example, SSTI frequent cites the fact that even when there are no arrests, apprehensions or even suspects, there is often crucial evidence that is gathered which can result in convictions even years down the road.

Forbes describes the value of this supposed benefit as “overstated”, which I believe is a considerable understatement.

For example, a ShotSpotter audio recording was used in the prosecution of a shooting that occurred in Mahoning County, Ohio. However, the expert witness provided by ShotSpotter could not provide details on key findings that would have corroborated other testimony.

According to the Assistant county prosecutor, “We still would have been able to secure conviction [without ShotSpotter].”

Effectively, ShotSpotter is just coming up with creative excuses for why law enforcement should continued spending tax payer money on a system that has been thoroughly and repeatedly debunked.

Regardless of whatever any data says and regardless of the complaints from past disgruntled customers, if ShotSpotter could actually be seen to deliver a visible drop in gun violence then it would certainly be able to win over more potential new customers.

It is therefore not surprising that ShotSpotter is out there making aggressive “ cause-effect” claims about how SS directly reduces the incidence of violence.

Each of the following links come from ShotSpotter’s investor relations department. They show that ShotSpotter is marketing itself on the basis that “using ShotSpotter leads to lower gun violence”.

ShotSpotter claim:“’We are extremely pleased with the dramatic decline in gunshots Fall River has seen over the last few years…While the 57.4% decrease in shootings is substantial, there is still much more to do…”

ShotSpotter claim:“ Among U.S. cities using SST’s ShotSpotter technology, three of the top five with largest reduction in gunfire incidents from 2014 to 2015 were: New Haven, Conn. (-38.5 percent, Atlantic City, NJ (-35.4 percent), and San Francisco, CA (-34.6 percent).”

Despite the alarming headlines over high profile mass shootings in places like Vegas and Texas,gun violence has actually been on a steady and consistent decline across the entire US.

The tables below show that gun violence has been steadily deceasing across the US for the past 10 years. This includes for the country as a whole as well as for wide range of individual cities which have never used ShotSpotter at all. Yet ShotSpotter continues to claim the its system is responsible for these declines.

Quite obviously this assessment stands in stark contrast to the data presented above and the detailed experiences of law enforcement.

As can be seen clearly in the table above, cities across America have seen a very steady decline in gun violence, whether or not they had any use of ShotSpotter at any time ever.

The implementation of ShotSpotter technology is not what is “causing” the reduction in gun violence any more than SS is “causing” the sun to shine in those cities. But ShotSpotter is more than happy to claim credit for “causing” this reduction which is in reality just part of a decade long macro trend.

ShotSpotter’s claims that it somehow results in a reduction in gun violence are entirely bogus and unsubstantiated.

Disclosure: This article is the opinion of the author.The author is short SSTI. The author may trade one or more securities mentioned within the next 72 hours.

Shares of RH are being driven sharply higher as a result of financial engineering being conducted by RH’s CEO Gary Friedman. Throughout this article, please understand that the described reductions in share count have nothing to do with any type of meaningless “reverse split”. Instead, with RH these are actual and permanent reductions in share count which are having a very predictable effect on the price of each remaining individual share.

Right now some shorts appear to be taking the view that “if RH was a good short at $30, then it must be an even better short at $90”. But in fact, the share count has been reduced so aggressively (via share buy backs) that the market cap of RH is only up by 30-40% since April. Moreover, this moderate rise in valuation is arguably not far out of line with the recent improvements in financial results (and outlook) as announced in September. The September announcement alone saw the share price spike 45% in single day. The shares repurchased by RH were bought at far lower levels and much of these purchases were conducted with cash (not just debt), such that even the comparable rise in enterprise value is also far much lower that this sharp rise in the share price. In other words, comparing the price of a single share between one period and the next is no longer a consistent picture of the valuation of RH as a whole.

So here is what is happening:

In May of 2017, RH’s CEO Gary Friedman was quietly awarded a staggering nine figure incentive package if he can somehow engineer the share price to $150 or higher. Precisely how he achieves this goal is entirely irrelevant.

If Friedman is successful, the value of the total awards to him will exceed $500 million. At least $25 million of this will come to him within just the next few months. All that is necessary for Friedman to receive this payout is the financial engineering and ongoing reduction of share count coupled with even just very slight improvements in RHs business (in fact, whether real or perceived).

Mr. Friedman did not waste any time in putting his plan into action.

Within just two days of that award (on May 4th, 2017) RH quickly announced a $700 million share buyback to sharply reduce the share float. Some were surprised at the buyback because RH’s stock price had already been rising towards the highest prices of the year (then closing in on $50).

Even more surprising (to some) was that within just 50 trading days, RH had announced that it had already completed the entire $700 million share repurchase, accounting for a significant portion of the daily volume during that time.

What I will describe below is how Friedman is now using a combination of positive cash flow and new debt to further reduce the share count. Friedman is effectively conducting a “stealth/quasi/creeping” going private in order to drastically reduce share count. Ultimately, for Friedman to take home his nine figure package, the equity float must go lower. And this is what is happening. The impact on the share price is entirely predictable.

Throughout 2017, RH has already repurchased half of its outstanding float at an average price of $49.45. The share price has already nearly doubled since those purchases.

But what about the all of that debt ?

Because of its increased leverage, the market has been very focused on RHs “capital structure”. But changes in leverage can now cut both ways. As a result, when RH suddenly announced three weeks ago that it was already paying down its $100 million second lien term loan (within just 3 months of it being issued), the stock quickly shot up 20 points from the $70s to the $90s, quickly hitting new 52 week highs. And yet clearly that was a just relatively small deleveraging.

Of RHs remaining debt, the majority ($650 million) is in the form of convertible debt with strike prices of $116 and $118. And now suddenly these conversion prices are quite squarely within range.

But….did you also know that in 2014 and 2015, RH had already purchased complete “bond hedges” from underwriter BofA-ML to fully neutralize dilutiononce those convertibles convert at prices over $116 and $118. There is therefore no dilution until the share price exceeds well over $170.

In 2014 and 2015, RH paid BofA-ML over $130 million for the long legs of these bond hedges to neutralize dilution.

(Terms, details and dilution tables for the bond hedges are included below).

Yet the market has missed the details of these convertibles and bond hedges because just a few months ago, the share price was still below $50, making conversion seem highly unlikely.

(And quite frankly, I am very skeptical that many investors ever even knew about these massive bond hedges in the first place.)

Even aside from earnings announcements, Friedman has made use of other ongoing announcements to propel the share price higher over the past 5 months. There was the announcement of the share repurchase, the announcement of Friedman’s own open market purchases of $2 million in RH stock in the $70s and then the announcement of the early repayment of RH’s second lien notes in October. Each time, these separate announcements have driven the share price sharply higher. This is how we have gotten from the $40s to the $90s in just 8 weeks.

The next catalyst for a sharp spike higher

And now in just 8 trading days from today, RH has suddenly decided to conduct its first “investor day” after more than two years. In the past, RH has made very visible use of such events to make announcements which then sent the stock sharply higher.

There are a variety of announcements that Friedman could be expected to make at (or in advance of) this “investor day”.

The most obvious announcement would be that RH would announce the simple approval of the next leg of its ongoing share buyback.

Or RH could announce a subsequent reduction of leverage.

Or Mr. Friedman could simply reiterate his recent very bullish views on RH’s near term prospects, both in the US and in Europe.

Given the 48% short interest in RH and the moderate trading volume, any of these announcements could easily fuel an immediate and very sharp spike in the share price.

In the event that RH announces yet another shift in the capital structure (i.e. the next leg of the stock buyback or the next debt pay down), such a spike would most likely be permanent rather than temporary.

In the near term, if the share price stays above $100 (up just 11% from current levels) in the next few months, Mr. Friedman will receive an extra $4 million under the recently awarded incentive package.

But if the share price goes North of $150 then just that first near term incentive award swells to $25 million to be doled out to Mr. Friedman in just the next few months.

So ask yourself this: in its first investor day in more than two years, and with $25 million looming in near term incentives, do you think Mr. Friedman will say something positive or something negative

Back in August, I published my long thesis on Hertz Inc. (HTZ) when the stock was at just under $14. Many people thought (and said) that I must have lost my mind. The share price (they said) was clearly wildly higher than what Hertz’s troubled fundamentals could justify. And Hertz’s “capital structure” (they said) would only serve to turbo charge a decline in the share price. Just before I published my article, a SELL recommendation from Barclay’s raised the specter of bankruptcy, sending Hertz’s stock plunging by 40% in 2 days.

Against that, all it took was for the slightest of ongoing results to be “less awful than expected” and Hertz was set to skyrocket. And this is exactly what happened. With short interest at greater than 50% of the float, a modest rise in the share price turned into a sharp spike and Hertz’s share price jumped 40% within days. The share price then quickly went on to double to around $28. Hertz is now up by around 75% since where I wrote about it. I am currently long a moderate amount of Hertz.

As I was with Hertz, I am totally aware of the short thesis on RH. In fact, just as with Hertz, I even agree with many of the FUNDAMENTAL observations of the short thesis on RH.

But I will show what the market has missed and why shares of RH are set to very quickly spike sharply higher from here (and then stay much higher going forward). And just as with Hertz, it is the “capital structure” (and changes to the capital structure) which will now turbo charge the share price much HIGHER rather than lower.

Important: Once we saw what Carl Icahn was doing with Herbalife (HLF), it then became very easy to see what Icahn was doing with Hertz. It became very obvious that the price for any single share for each of those companies would have to rise, even despite very visible challenges with their underlying fundamentals. Changes in the share price between one period and the next were no longer comparable for valuing the company as a whole.

With HLF, I tend to agree strongly with Ackman (bearish) about the business, but even more strongly with Icahn (bullish) on the expected direction of the share price.

We can now see similar tactics being used by RH CEO Gary Friedman to “engineer” the RH share price to much higher levels. It has worked with HLF. It worked with HTZ and now it will quickly work with RH.

*** Section 3: Looking at the RH short thesis

By now, the short thesis on RH is quite well known and has been widely disseminated for over two years in a variety of media outlets including Grants, The Wall Street Journal and Baron’s.

In fact, on a strictly fundamental basis, I actually agree with many of these obvious concerns raised by the financial media. But it just doesn’t matter. The share price is headed sharply higher. These media outlets had all raised similar concerns about names like Hertz and Herbalife as well, even as those stocks went on to soar dramatically in price. Notice the prices of RH at the time of these articles (as well as their titles).

RH sells very high end (i.e. “over-priced”) furniture to a small demographic of upper income customers. The overall size of that demographic is already quite small and their continued purchasing power is heavily dependent upon ongoing appreciation in real estate and stock market assets. Revenues at RH have steadily increased, and have been driven by a significant expansion effort into a) more stores and b) larger and larger store formats. Once the economy slows (and with it the real estate and stock market values), purchases from these customers will slow sharply. That store expansion (which has so far helped RH) will then become a weight on the business. Many shorts also assume that any decline in RH will then be turbo charged by recent changes in its “capital structure”. This is because RH has been aggressively been buying back its own shares and financing those purchases by issuing debt. Leverage has therefore increased sharply.

But against this short thesis, there is a very visible wild card which has been a significant head scratcher for anyone who has been short the stock.

RH CEO Gary Friedman has also been using his personal funds to aggressively acquire millions of dollars worth of RH shares in the open market. His earlier purchase of nearly $1 million in July of 2016 could arguably be justified by the low price of $27.50 at the time.

But then in September of 2017 (just 6 weeks ago) Friedman again used his personal funds to purchase an additional $2 million of stock at an average price of $70.28. Friedman’s latest purchases occurred at the highest share prices for RH since late 2015. Friedman’s most recent purchases at $70.28 in September marked the beginning of the subsequent rise in the stock from the $70s to the $90s, a further 30% rise in just those 6 weeks.

So let’s look at what the larger market is missing here.

*** Section 4: Smarter shorts have been very QUIETLY reversing their views on RH

(Hint: No short seller is going to tell you that they are desperately looking to get out of their position in RH. Duh. Given the information below, I would be rightfully be quite skeptical if anyone who was short RH started aggressively trying to convince me to sell my shares of RH.)

A few months back, short interest in RH had exceeded 60% of float. This is what we call a “suicide short”. With the stock having doubled since this time, it has certainly lived up to the name “suicide short”.

Since that time, the short interest has fallen to 48% of float. It is still basically a “suicide short”, but clearly some of the smarter shorts have started to comprehend the implications of the ongoing financial engineering by RH’s CEO, which will continue to send the share price ever higher.

And note that even this small level of short covering over the past two months has contributed to the sharp rise in RH’s share price. From September through October, short interest fell only modestly from 58% of float to 48% of float but the share price rose by more than 20 points during that time (and this continued rise was already AFTER earnings had been released). So if there is a larger unwinding of short positions, then we should expect a much larger upward move in the stock from here.

Also remember that on September 7th RH shot up by 45% in just a single day, from $49 to $71, following the release of better than expected earnings and guidance. So that is the level of short term price volatility we have come to expect from RH when it puts forth a meaningful new announcement.

At nearly 50% of float, the remaining short interest is still absolutely massive. Even attempting to slowly get out of small positions is noticeably pushing up the price of RH. The current short position amounts to fully nine days of trading volume.

This is why existing shorts are trying to be very QUIET about getting out of their positions in order to minimize a potentially significant short squeeze from here.

But as we have often seen in the past, there will inevitably be some “dumb money” that gets badly burned.

The dumb money is staying short on the simple view that “if RH was a good short at $30, then it must be a great short at $90”.

*** Section 5: The Bull Thesis for RH (on the share price, not the business)

Share price vs. valuation

Yes, during 2017 shares have more than tripled off of their sub $30 lows. And yes, anyone who has been long or short during this time has participated 1:1 in this 60 point move.

But it is very important to understand that this categorically DOES NOT mean that the VALUATION of RH has tripled. In other words, despite the share price move, RH has not necessarily become equally expensive as a company.

The all time high for RH was just over $100 in 2015. So as we now approach that level again, some people are tempted to try to call the top in the stock.

But because of the changes to the capital structure since 2015, the market cap of RH is less than half of what it was back then, while the enterprise value (“EV”) is actually half a billion dollars LOWER – EVEN at the same share price of around $100.

Conclusion: Because of continuing changes in the capital structure, comparing the share price from period to period is no longer an accurate reflection of changes in the value of RH as a company.

Just during 2017, RH has been making use of very aggressive share repurchases to cause a PERMANENT reduction in the outstanding share count. As a result, despite the “triple” in the share price, the market cap has only risen by less than 50% since the end of Q1.

In addition, aside from the debt funding much of the share repurchase were conducted with cash and the average purchase price was at just $49.45. As a result, the rise in EV has also been far less than what would be surmised by looking at the share price.

Think of it this way: RH borrowed around $600 million to buy back $1 billion of stock at the time. The balance was paid for with cash. The value of that debt stayed constant at around $600 but the value of those shares repurchased has since nearly doubled to nearly $2 billion.

And remember that the 50% rise in market cap that we have seen this year was actually coming off of a very low base. The share price had been sitting at deep multi year lows.

In addition, some amount of bounce from those levels is arguably quite justifiable given that in September:

GAAP revenues increased by 13% (relative to single digit growth at competitors).

Earnings came in at 65 cents per share vs. 44 cents in the year prior (an increase of 48%)

RH boosted guidance on 2017 revenues to $2.42-2.46 billion

RH boosted 2017 net income guidance to $70-77 million

Analysts have also upped their outlook for RH substantially. Consensus wall street expectations for earnings this year has increased by 43% over the last 6 months to $2.60 currently from a low of $1.82.

The recently improved outlook is actually quite significant.

In fact, we can see that RH currently trades at around 26 times consensus earnings estimates. This is actually slightly LOWER than where RH has traded vs. estimates in the past. It is also steeply lower than the 30-40x multiple where RH traded two years ago (when the stock was also near $100). So the stock price comparison of today is truly no longer comparable. It is apples to oranges.

RH share price multiple vs. consensus earnings estimates

My only point is that some level of valuation increase is certainly merited vs. 6-9 months ago. And once we factor in changes to the capital structure, the moderate rise in RH’s overall valuation is not excessive.

SO HERE IS THE BIG QUESTION:

Question… So are these share repurchases just “financial engineering” to artificially make the price of each share higher ?

But…. It simply doesn’t matter. The share price will continue to go much higher as the actual share count continues to decrease. In addition, even very small improvements in earnings (or even just in guidance, Mr. Friedman ! ) will start to have a disproportionately larger impact on the price per individual share.

Anyone who has been long or short the stock during 2017 has participated 1:1 in the share price rise. And they will continue to participate 1:1 as the share price moves up towards its next level of $150. Because that is the level to which CEO Gary Friedman needs to “engineer” the stock price.

*** Section 6: In 2017, Friedman was given a NINE FIGURE incentive to engineer a $150 share price for RH

On exactly May 2nd of 2017, RH quietly awarded CEO Gary Friedman a massive nine figure contingent equity compensation package which aggressively incentivizes him to increase RH’s share price. The precise method of HOW he achieves this price is entirely irrelevant.

The incentives to Friedman have an “exercise price” of $50 per share but are “restricted” until the share price reaches prices of $100, $125 and $150. If he does not meet these share price targets, then the options are restricted for a period of 20 years. Mr. Friedman is currently 60 years old.

As noted, the options contain time restrictions and are awarded over a four year period. But under certain conditions, the options all get awarded immediately AND they then vest immediately too. We will see this below.

On the date of that award in May 2017, RH closed at $48.62 such that the large award size seemed not-so-relevant vs. their restriction prices of $100-150. (Obviously they are suddenly looking much more relevant now that RH has doubled in just 6 months.)

And here is where it gets interesting.

On May 4th 2017 (just two days after Friedman received his incentive) RH suddenly announced that that it had authorized a $700 million share repurchase program.

With his massive incentive package in place, Friedman didn’t waste any time in aggressively reducing the outstanding share count. Within just 50 trading days (on July 14th) RH announced that it had alreadycompleted the entire $700 million repurchase. Wow, that was fast.

In fact, this $700 million buyback followed on the heels of a $300 million buyback in Q1 (just a few weeks earlier) which had been effected in the run up to Friedman’s incentive package being awarded to him.

Together this means that in just a six month period, RH bought back 20.22 million shares, cutting the outstanding share count by half (49.6%) from where it stood in early 2017. Against the total outlay of $1 billion, we can see that RH bought those shares for $49.45 (and they are now trading at around $90).

So yes, the share price has tripled since Q1 from below $30 to over $90. But because the share count has been cut in half, the market cap has only increased by 50% from those deep multi year lows.

And again, since that time we have seen sharp improvements in revenues, earnings and cash flow, such that a higher valuation is certainly justifiable.

As a result, against all expectations, the first of Friedman’s trigger levels (the $100 mark) is suddenly squarely in sight. As we will see below, from here it will be very easy to for Friedman to get the price per share to $150 using the exact same technique. And the massive short interest is only going to help Friedman make this happen even sooner.

From the RH Proxy Statement (dated later in May 2017) we can see the breakdown of how these options are awarded.

The takeaway from the table above is that if Friedman can keep the stock above $100 (just 11% above current levels) by the 1st anniversary of his award (i.e. in May 2018) he will be awarded an extra 83,333 shares which would be worth an additional $4.2 million. (Remember, the strike price is $50 such that the intrinsic value of the awards would be $100 minus $50=$50.)

But….

If Friedman can get the stock a bit higher, to above $150, by May 2018 then two things will happen.

More importantly, under the schedule above, Friedman would also get three times as many underlying shares.

In other words, if CEO Gary Friedman can get the share price over $150 by May 2018, just his FIRST brand new additional award will suddenly be worth a cool $25 million just a few months from now. It’s a pretty nice incentive package.

So ask yourself this: what do you think Mr. Friedman has in mind to announce at his first “investor day” after more than two years ?! We will find out in just 8 trading days.

Identical awards are to be given to Friedman over each of the four upcoming years, such that in addition to his paid salary and bonus, and in addition to the shares that he already owns, this single incremental incentive piece then pays Friedman an additional $100 million over four years

Looking back to that $2 million purchase of RH stock that Friedman made in September. Friedman bought those shares at $71. So if the stock price does rise to $150, he would make a profit just over $4 million. But his incentive awards would end up being worth over $100 million.

It is very clear to me that these ongoing purchase of stock by Friedman have more to do with “signaling” so as to help him get the stock price to $150. They have less to do with the actual economics of those newly purchased shares. Signaling or not, these purchases will most likely have the desired effect and will continue to boost the share price higher.

As a result, I fully expect to see Mr. Friedman continue to make more open market purchases even at prices well over $100. It only makes sense. And when the CEO starts announcing his open market purchases at all time high prices of over $100 per share, I fully expect that this will have the exact effect that Mr. Friedman desires (in other words, more buys by Friedman will again drive the even stock higher).

Either way, after 40 years in the retail business and at the age of 60, Mr. Friedman is getting within pistol shot of locking in a near term nine figure payout.

*** Section 7: OK…but what about all of that debt ?

One thing keeping many shorts in place on RH is the fact that these massive share repurchases have been largely financed with debt. Because of the share repurchases in 2017, RH’s total debt load went from $532 million in July of 2016 to $1.15 billion by the end of the July 2017 quarter (announced in September 2017).

So basically an extra $600 million in debt to take out $1 billion in stock.

(The $1.15 billion debt figure is the number disclosed in July by RH. RH also has $233 million in “capital leases” associated with its properties which some analysts treat as debt).

Beyond that debt, the balance of the funds used to buy back stock were obtained from operating cash flow as well as from cash on hand. The cash on hand was largely the result of previous bond offerings.

We can see quite clearly that RH’s share price is indeed very, very sensitive to any changes in its capital structure. But this knife cuts both ways. Any REDUCTION in leverage can also send the share price spiking sharply higher.

On October 10th RH announced the early repayment of its $100 million 9.5% second lien term loan. At the time, RH was still trading at just $72. In the three weeks that followed, RH then quickly soared by more than 20 points as investors started to recalibrate their assessment of RH’s “Capital Structure”.

Much of that $100 million repayment was actually more of a refi, with RH using a 2.75% asset backed facility to make the payment. Even though only a portion of that term loan was actually repaid with cash, the share price still spiked sharply higher.

My point is that when we (very soon) see even larger reductions in leverage, we should expect to see much greater upward spikes in the share price.

In fact, that tiny refi / pay down was very small potatoes compared to what is coming next.

Just a few months ago, when RH’s share price was below $50, no one seemed to focus on the fact that $650 million of RH’s debt is actually convertible into stock.

The conversion feature may have seemed largely irrelevant at the time because the conversion prices on those convertible bonds are set at $116.09 and $118.13 which was more than 100% above the prevailing share price just few months ago. It seemed safe to assume that if there was to be any eventual conversion than it would be far into the future.

But as recently as September (after the share price had spiked above $70), RH was already telegraphing it investors how it viewed this “debt”.

For some reason, RH began “carving out” the calculating of those convertibles. In the September earnings release, RH suddenly described its total indebtedness as follows. (Note the carve out of the converts, as well as the advance disclosureof the bridge loan repayment which then happened 4 weeks later).

Outside of the convertible notes that are due in June 2019 and June 2020, we had aggregate debt of approximately $504 million at the end of the second quarter, including a $100 million second lien bridge loan that we expect to repay in full by year end.

But now with the stock closing in on $100, those conversion prices become much more relevant because that “debt” can be extinguished if the share price stays above the $116-118 levels. It is now becoming clear why RH was alerting us to this back in September.

And then it gets even better. The “bond hedges”.

Even fewer people are aware that back in 2014 and 2015 when RH issued those convertibles, the company simultaneously entered into “call spread” transactions (AKA “bond hedges”) with BofA-ML (the convert underwriter). The purpose of these call spread transactions was to neutralize any eventual dilution which would occur when these bonds eventually converted into stock.

Under the terms of those call spreads, RH completely neutralizes any dilutionthat would occur when the stock prices exceeds $116 and $118. This was a separate contract with BofA-ML such that even many of the convertible investors are likely unaware of it.

So instead of having dilution at $116 and $118, there is no dilution under the convertibles until the share price exceeds well over $170, even when they are converted.

This type of an option package is certainly not free. RH paid a huge sum of money to BofA-ML for the massive benefit of incurring no dilution under the convertibles until North of $170.

But those large payments were made by RH back in 2014 and 2015, such that all of the cost is in the past, while all of the benefit is in the present.

The full details of these option purchases by RH can be found in the SEC filings. For example, on the “long” leg of the call spread (“bond hedge”) purchases, the terms are disclosed as follows:

The documents below were from 2014 and 2015. As such I currently believe that most current investors are fully unaware of them.

NO DILUTION. WHAT TO LOOK FOR: In the tables below, look to the column on the far right to see the net impact of the convertible vs. the call spread which was purchased by RH. In each case you will see that “total expected dilution” is zero until share prices well in excess of $170.

BOND HEDGE #1 – NO CONVERT DILUTION UNTIL SHARE PRICE OF OVER $171.98

BOND HEDGE #2 – NO CONVERT DILUTION UNTIL SHARE PRICE OF OVER $189.00

Re-evaluating RH’s total debt picture

In a Form 8K released in July 2017, RH included a table showing its total indebtedness following the $700 million repurchase.

Total debt was listed as $1.15 billion, including the $100 million term loan and $650 million of converts.

Some portion of that $100 million term loan has already been paid down. And if Friedman can engineer even a slightly further rise in the share price from here, then the converts will get extinguished (with no dilution until North of $170).

Note: From the multiple disclosures above, we should assume that the information on total indebtedness in this table above will be subject to significant change in the very near future.

*** Section 8: Accelerated vesting. The end game for RH and Friedman.

OK. In this section, your initial reaction is likely going to be one of heated disagreement. But please hear me out. I have occasionally done some decent work in the past.

In addition to the equity incentive awards above, totaling $100 million, Friedman also has numerous other past incentive awards. These are also subject to vesting periods and trigger prices at over $100.

After 40 years of working in the retail business, and at the age of 60, Mr. Friedman is now within striking distance of getting all of these option awards to be exercisable and immediately vested. If this happens, Mr. Friedman then gets to quickly retire with a very solid and immediate nine figure payout.

Keep in mind that just a few months ago that no one would have thought that RH’s share price could possibly by closing in on $100. And yet here we are.

So how does Friedman turn these equity incentives into a nine figure reality in the very near term ?

Again. Just hear me out.

Step one. Reduce the share count to a level where the price per individual share is well over $150. The aggregate value of the company is now increasingly being shifted onto bond holders, and across a smaller and smaller number of common shares. Again, just use common sense. As the SHARE COUNT declines, the proportionate SHARE PRICE increases for each individual share. Duh !

Step two. Conduct this process in a way that minimizes further increases in the enterprise value. Use as much operating cash flow as possible and maximize the impact of prior share repurchases at much lower levels. For example, RH borrowed $600 million to repurchase $1 billion of stock. The stock price then nearly doubled. As such, a very slight increase in debt (ie. EV) was accompanied by a share price that jumped nearly 100%.

In the recent earnings announcement, Mr. Friedman has very explicitly told investors that this is exactly what he is doing and exactly what he will continue doing. Note, this is now turning into a huge pile of cash flow which can be used to buy back more stock or pay down debt. Here is what Friedman told investors in September:

Our efforts to optimize inventory and reduce capital spending generated $282 million of free cash flow in the first six months of 2017, and we now expect to generate approximately $400 million of free cash flow for the year, which should address any concerns about our balance sheet and debt ratios. We have reinvested the $282 million of free cash flow generated in the first half, and the $263 million of cash and investments on our balance sheet at the beginning of the year towards the repurchase of our stock, which we believe is an excellent allocation of capital for the long-term benefit of our shareholders.

And again, this happened to be the same announcementin which Friedman told investors 4 weeks in advance about the upcoming “repayment in full”of the $100 million in second lien notes. When that repayment did happen 4 weeks later, the stock quickly shot up 20 points.

Step three. Even though the price for a single share is now much higher, the enterprise value is actually NOT much higher. In other words, depending on the eventual share count (and the split between equity vs. debt) a potential acquirer would have no problem paying $100 per share, $200 per share or $1,000 per share, or whatever. All they care about is the overall valuation of RH.

This is why I referred to Friedman’s approach as being a “stealth/quasi/creeping” going private. He is shifting the value of the company onto debt holders (and out of the equity markets) with the equity portion being spread across fewer and fewer shares. When the share count gets small enough (and the share price high enough), he can then sell the entire company if the overall enterprise value merits such a sale.

Again, even when the stock hits $150, the company will certainly be nowhere near 5x as expensive as it was at $30 just 6 months ago. With the changes in the capital structure, those numbers are no longer comparable.

Remember that RH’s enterprise value is now substantially lower than it was in 2015, even as its performance is on a strong upswing. RH is also now trading below where it has historically traded vs. forward PE estimates.

So how does Mr. Friedman sell all of RH for an enterprise value North of $3 billion. (Again, forget about the share price. With a flexible cap structure, the share price could be engineered to end up $50 or $500 and it wouldn’t matter to an acquirer.)

There are two obvious potential acquirers both of whom could easily afford to snap up RH. And for each of these parties, their motivation is strategic such that a swing in valuation of even 20-30% in one direction or their other would not be the deciding issue.

A sale to Amazon

I know. I know. It is getting cliché for people to keep speculating that Amazon (AMZN) is going to buy every public company in sight. But with RH, it actually makes very good sense.

Amazon’s recent purchase of Whole Foods surprised many people. It communicated to all of us a very significant strategic focus for Amazon. First, Amazon is now actively looking to expand into businesses with bricks and mortar operations. Second, Amazon is focused on acquiring brands and customers in at the high end of the price/quality spectrum.

In both of these respects, RH is identical in furniture to what Whole Foods is in groceries. Amazon’s visible push to the higher end is also why Amazon did not buy Kroger and it is exactly why Amazon would never want to buy Wayfair (W).

I am certainly not alone in sizing up Amazon’s ambitions in expanding into the high end bricks and mortar furniture business.

In May 2017 (just 6 months ago), Fortune Magazine made a great pitch for why Amazon will do exactly that.

A potential sale of RH to Williams Sonoma is potentially easier and more interesting, yet many investors are likely tempted to dismiss the idea unfairly.

Williams Sonoma already has an enterprise value of nearly $5 billion, but it has almost zero debt. As a result, levering up to acquire RH would certainly be quite achievable.

Williams Sonoma owns competitors to RH including Pottery Barn and West Elm. But sales growth has been consistently stagnant. While Williams Sonoma has been growing only in the low single digits, RH has been killing it in the low to mid teens in terms of revenue growth (including in the most recent quarter). The reason why is that RH has built a sustainable brand and a loyal customer base.

As a result, Williams Sonoma would not need to penny pinch and try to lock in a low end valuation in acquiring RH. It could justify paying a premium price simply due to the very obvious synergies that the acquisition would bring. Both of the companies are headquartered in Northern California, making integration very easy. Both companies distribute fairly similar product lines, which would then allow for the consolidation of third party manufactures, shipping and distribution. There would be instant cost savings from day one.

As we know, RH CEO Gary Friedman used to be president and COO of Williams Sonoma. When he was passed up for the CEO spot 16 years ago, he then came on as CEO of RH. And RH has since done quite well in creating a brand and capturing market share.

The one argument I have heard against such an acquisition is that Friedman may now insist on getting that CEO spot for the combined entity post acquisition. But Friedman is now 60 years old. After 40 years in the business, I think he would be willing to let that honor pass by if it involved him getting immediate vesting on over $100 million in payouts.

Again, I understand that many people are still stuck thinking that RH was “expensive” when it was at $30. As a result, trying to get comfortable with the notion of a buy out at $150 is going to be tough.

But when we factor in the changes to the capital structure, the improvements in the business and then look at the overall valuation, the specific share price becomes irrelevant.

Either Amazon or Williams Sonoma could easily justify the purchase of RH at current or higher levels. And (as we have already seen) further financial engineering by Friedman could easily get the share price to over $150 without a commensurate rise in the valuation (“EV”) of the company.

(Note: The short interest of nearly 50% of float is not really part of my bull thesis on RH. But the unwinding of short positions will certainly cause the stock to rise much sooner (and much higher) than it would do otherwise based on just the financial engineering.)

RH’s CEO Gary Friedman began his career in the stock room of The Gap (GPS) in 1977 following a short stint in community college where he reportedly received fairly low grades. Against those humble beginnings, Friedman has been singularly ambitious.

From increasingly senior roles leading Gap, then Williams Sonoma (WSM) and now RH, Friedman keeps climbing the retail ladder. And when one ladder has no more rungs, he simply switches ladders.

Friedman is now 60 years old and just 6 months ago was given a nine figure incentive package which can be entirely obtained if Friedman can simply financially engineer RH’s share price to over $150. Within just 2 days of Friedman receiving that award, RH suddenly announced a $700 million share repurchase, which was then fully executed in just a few weeks.

The financial engineering (along with some positive announcement from Friedman) have seen the stock triple in 2017. But the deeply reduced share count means that the valuation is not all that much higher than where it was in April. At the same time, RHs financial performance has undeniably shown visible improvements which do merit a higher valuation.

There are a variety of levers that Friedman can pull in order to get the share price to $150.

As we saw following a small (and only partial) pay down of the $100 million term loan, RH’s share price is now extremely sensitive to and changes in leverage. The stock quickly jumped 20 points. As the share price now nears the $116 and $118 conversion prices of RHs two convertible bond issues (totaling $650 million), investors will rightfully begin to recalibrate their view on RH’s share price vs. perceived leverage. I very strongly suspect that most investors have been totally unaware of the massive “bond hedges” that RH purchased back in 2014 and 2015, which fully neutralize any dilution from the conversion of those bonds into shares until the share price reaches over $170.

As we saw, in the most recent earnings announcement, RH is already “carving out” the calculation of that convertible debt when it describes its total indebtedness. That was the same earnings announcement that disclosed the intention of paying down the $100 term loan fully 4 weeks before it actually happened.

Disclosure: I am/we are long RH.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is long RH and HTZ. The author may transact in various securities mentioned within this article within 72 hours.

HIIQ designs these plans on behalf of insurance carriers and discount benefit providers and then markets them primarily through its internal distribution network and an external distribution network of independently owned call centers.

*** 3 – INVESTMENT THESIS

The theme I will show repeatedly below is one of “delay, downplay, dismiss, deny” which then allows insiders to aggressively dump their shares.

Over the past 7 months, shares of HIIQ rose from below $5.00 to over $35.00 – a seven bagger – despite only marginal apparent improvements in its business.

During this time, revenue has increased slightly, and HIIQ has successfully managed to lower its heavy dependence upon STM plans. But this does nothing to absolve HIIQ of its massive undetermined liabilities stemming from fraud investigations which now span fully 42 states. And the problems then get worse from there.

HIIQ is now set to quickly plunge by at least 80% to $6.00 or below. Such a decline would really just put HIIQ back to where it was right at the time of the 2016 US election. (see chart above) In reality, I strongly expect that there is a high likelihood that HIIQ ultimately plunges to below $1.00 and faces delisting. No, this is not an exaggeration. Keep reading.

Consider the following:

HIIQ is now facing fraud investigations or cease and desist orders from 42 different states.

Recently emerged data points now indicate that legal liability will be in the range of $100 million or more (as opposed to the mere $1 million number which has been published by certain authors who recently spoke to HIIQ management).

On the heels of these mounting state fraud investigations, in June of 2017 HIIQ was just rejected for licensure in its home state of Florida. In its appeal to the regulator (also from June of 2017), HIIQ then PRIVATELY cited to the regulator the specter of a disastrous “domino effect” from this rejection by which licensing denials will then spread to the other states in which HIIQ does business.

The scathing letter from the regulator cited multiple reasons for the denial of the license, in direct contradiction with disclosure to investors by HIIQ. For example, as part of its independent background check, the regulator uncovered multiple undisclosed legal actions against multiple HIIQ insiders. When confronted with this by the regulator, HIIQ refused to respond. Again, HIIQ disclosed something very different to investors.

Delay, downplay, dismiss, deny

HIIQ has retained an expensive law firm and has now submitted, re-submitted and appealed for this license at least 4 times over the course of 2016 and 2017. Now that the final rejection is imminent, HIIQ has somehow tried to suggest that it doesn’t even need such a license in the first place.

As of the most recent disclosure, the Florida regulator is set to publish its final determination in October 2017 (a few weeks from now). For the sake of completeness, I have already sent a copy of this entire article to the Florida regulator.

The slew of massive legal and regulatory problems facing HIIQ is set to unravel in the very near term. There are multiple near term catalysts. The most visible catalyst is coming in just a few weeks in October 2017.

HIIQ has repeatedly attempted to suggest that it is actually some other party (such as HCC) that is being investigated or is at fault. Yet anyone who reads the actual legal filings can immediately see otherwise. In the fraud complaints from 42 state governments, the repeated theme is that HIIQ has engaged in fraudulent sales practices while operating without a license. And now HIIQ has brazenly attempted to suggest to investors that maybe it just doesn’t need such licenses at all.

And here is where it gets really interesting:

Even as HIIQ passionately encourages investors to buy, the insiders have been aggressively dumping their own shares. So far in 2017, HIIQ insiders have dumped millions of shares taking in over $50 million. Keep in mind that just a few months ago, the market cap of the entire company was less than $200 million. In November off 2016, the market cap was just $70 million.

Notice that insiders were aggressively dumping a huge volume of shares even when the price was more than 50% lower than the current level, at just $14. Selling has come from all corners, including the founder, the CFO, CTO and the CEO of its Healthpocket division.

History of insider sales:

Delay, downplay, dismiss, deny

In fact, now that the legal consequences are rapidly closing in, management’s actions are becoming downright blatant. Last week (on Tuesday September 5th), after the stock had suddenly dropped from $37 to below $30, Craig Hallum put together a hastily arranged conference call for management to reassure investors. As expected, the stock briefly rebounded. Just hours after this impromptu call encouraging investors to buy, multiple members of management began disclosing additional large share sales by insiders, quickly amounting to $1.5 million over just two days.

New SEC filings were then released in the after hours beginning on September 5th, which continued to the end of the week:

As you read the magnitude of the problems below, keep in mind that HIIQ has a cash balance of just $27.5 million with which to run its entire business and then deal with all of these impending liabilities.

The recently revealed data points indicate liability of $100 million or more.

So you do the math !!

It will quickly become clear why I am saying that HIIQ has the potential to drop to below $1.00 and face ultimate delisting. Either way, given the unfolding of the events above, a $6.00 share price will likely prove generous by the time Florida makes public its decision in just a few weeks.

This dire prediction for HIIQ is pretty much in line with what I had predicted on five prior Craig Hallum trades. For reference, the five companies were Unipixel (UNXL), Neonode (NEON), Erickson Air Crane (EAC), TearLab (TEAR) and Plug Power (PLUG).

Just like HIIQ, each of these past stocks had quickly spiked by 200-800% following gushing support from Craig Hallum. As the share prices spiked, large share sales or equity offerings then followed. As soon as I exposed their terminal underlying business problems, each of these stocks immediately plunged by 30% or more. Each of the stocks then went on to by implode 80-100%, just as I predicted. Among these five companies, we then saw various combinations of SEC investigations, fraud lawsuits, bankruptcy and/or delisting. I am specifically including below my five past articles which were specifically focused on past Craig Hallum trades on similar toxic companies. I would strongly encourage readers to have a look. The similarities to what we see with HIIQ should become 100% obvious.

*** 4 – LOOKING AT FRAUD INVESTIGATIONS FROM 42 DIFFERENT STATES

Delay, downplay, dismiss, deny.

HIIQ is currently facing a tidal wave of fraud investigations, lawsuits and cease and and desist orders which now already extend to at least 42 states (that we know about so far).

In March of 2016, here was the initial action taken by the state of Arkansas Insurance Department following a sting operation which revealed unlicensed insurance sales in Arkansas. During additional calls, “several” company representatives misrepresented the insurance products in an attempt to sell insurance plans, not realizing that the person calling was actually The Arkansas Insurance Department.

Read this screenshot closely.

Within 60 days, in May of 2016, HIIQ had already received another cease and desist from the State of Montana, requiring the company to immediately cease and desist from selling insurance in the State of Montana.

Delay, downplay, dismiss, deny.

In July of 2016, HIIQ filed a very lengthy 8K announcing the appointment of Gavin Southwell as President and Josef Denother to serve as COO. Within the 8K, HIIQ spent 4 pages elaborating in deep detail the most minute details of the terms of employment for these two. And then buried in the 8K, 4 pages in, HIIQ included a single small paragraph disclosing the commencement of a multi-state investigation being headed by the State of Indiana. And now finally the company disclosed the Arkansas and Montana legal actions from months earlier. But by this time, anyone who actually made it through to page 4 of this 8K could see that the investigations had expanded to include Arkansas, Florida, Kansas, Montana, Ohio, South Dakota, and Massachusetts.

When HIIQ ultimately chose to provide more detail on these investigations in March of 2017, it attempted to portray its own role as being just one target among many players. Here is how HIIQ described the Montana fraud complaint. Keep reading and decide for yourself if this is an accurate representation or if it is wildly misleading.

HIIQ specifically emphasized that it was “among more than two dozen separate parties named”. But the reality is that the other parties being named in this Montana action were largely being named as a result of the fact that they were doing business with HIIQ.

These policies are routinely sold though misinformation and deception at the point of sale by individuals not properly licensed or appointed in Montana to conduct this insurance business.

“The HII scheme”

In fact, throughout this Montana action, the Montana State Auditor refers to the fraud directly as “the HII scheme”. The Montana fraud complaint includes only two graphics throughout its 25 pages. Both of these graphics specifically map out HIIQ’s role in the scheme, without any mention whatsoever of the “two dozen” other players emphasized by HIIQ.

Here are the ONLY TWO GRAPHICS from the Montana fraud complaint, both of which focus ONLY on HIIQ.

Delay, downplay, dismiss, deny.

*** 5 – NEWLY EMERGING DATA POINTS: LIABILITY OF $100+ MILLION

As various settlements from involved parties start to dribble out, we can begin to find data points to help us either confirm or contradict the disclosures from HIIQ.

For example, from recent settlement agreements for other insurers named in the investigations, it was specific term of the Consent Order was that it was “contingent upon Unified ceasing to sell through HII”.

In a recent article on Value Investors Club, the author had stated that HIIQ has also ceased doing business with HCC Life Insurance. He seemed to think that this was a good thing. But it now strikes me that this termination was more likely result of the multi-state investigation being headed by the State of Indiana naming HCC for its involvement with HIIQ.

This is really, really bad.

And then it gets even worse.

Multiple new data points relating to multiple states have recently emerged (including using HIIQ’s own disclosure). These now indicate that legal liability could be in excess of $100 million (and potentially much more).

In the recent 10K, HIIQ noted that a penalty of $100,000 to $315,000 was “probable” in the state of Montana. Such a low penalty caused the VIC author above to be optimistic that total penalties would only be around $1 million.

But in the Montana complaint filed by the Commissioner of Securities and Insurance (“CSI”), we can see that during the investigation period, HII is only said to have brought in revenues of $503,800.

In other words, in its own estimation, it is “probable” that HIIQ will be forced to pay in the area of 20-60% of its revenues that were generated in Montana.

Based on the past disclosure patterns from HIIQ, I believe I have a right to be suspicious that the estimate provided by HIIQ is still too low.

This suspicion is entirely borne out by looking at the next settlement (which HIIQ is obviously well aware of).

In the recent 10Q, HIIQ made reference to a recent settlement by a carrier for “the same set of allegations” by the Massachusetts Attorney General (“MAG”). HIIQ did not name the party by name and it stated that it was too early to predict any loss as it might apply to HIIQ.

In fact, HIIQ suggested that there may not be any loss at all !!

Delay, downplay, dismiss, deny.

Actually, a quick legal search reveals that the party who settled was Unified Life, which has been named alongside HIIQ in fraud complaints in other states. In fact, as part of Unified’s fraud settlement in Kansas (“KID”), an explicit term of the consent agreement was that it was “contingent upon Unified ceasing to sell through HII”.

Once we know this information, we can see from Unified’s settlement with the MAG that it actually paid more than 100% of all revenues it generated in the state of Massachusetts.

This settlement of nearly identical charges included Unified directly reimbursing residents for 70% of all premiums paid plus 5% interest per annum !!

Over the various time periods in question, HIIQ has generated over $300 million in total revenues. Feel free to make your own calculation on how to apportion these revenues across the 42 states that are currently investigating HIIQ and according to what portion of the revenues are applicable to the various investigations.

What you will find is that even by stretching one’s optimism and creativity, it is very difficult to come up with a liability that is less than $100 million, even using very conservative estimates.

As of Q2, HIIQ had just $27.5 million in cash. I expect that HIIQ will need to conduct a large equity offering in order to meet these liabilities. Even with its lofty current market cap of $500 million, this would present a meaningful challenge. At much lower market caps (such as the $200 million where HIIQ was just a few months ago) an adequate equity offering becomes almost impossible.

But clearly HIIQ has the full support of Craig Hallum who continues to enthusiastically recommend the stock despite the obvious problems.

Below is a screenshot showing how HIIQ chose to disclose this event to investors in the recent 10Q. In short, we are supposed to believe from the disclosure that it is just “no big deal”.

Apparently, after the notification of fraud investigations by 42 states claiming unlicensed selling, HIIQ now tells us that it is taking a “prudent” approach and seeking a license in Florida. HIIQ states that it was only rejected because “the company had not yet provided all information required”. HIIQ notes that the denial is under appeal, set to be finalized in October. In fact, maybe the Florida OIR won’t even require a license at all !!

With such muted and understated disclosure, it is no surprise that seemingly no one has even noticed this event.

Delay, downplay, dismiss, deny.

But actually, the rejection letter from the Florida OIR paints a dramatically different picture.

The references above to “material errors and omissions” refers to something bad. In fact, it is really, REALLY bad.

On its application to act as a 3rd party administrator, Florida asks the applicants if they have been a party to any civil actions over the past 10 years involving dishonesty, breach of trust, etc.

The HIIQ insiders repeatedly answered “no” to those questions. But then an independent background checkby the Florida regulator uncovered multiple such undisclosed legal actions against multiple HIIQ insiders. This includes both the CFO of HIIQ (Michael Hershberger) as well as its founder (Michael Kosloske). Even when pushed by the regulator, HIIQ refused to supply information over these undisclosed legal actions.

Note that together, Mr. Hershberger and Mr. Kosloske have sold over $40 million in HIIQ stock over the past few months.

As per the above rejection letter from the Florida regulator, even when confronted with the undisclosed legal actions against multiple insiders, HIIQ refused to respond or provide the information required.

*** 7 – IMPLICATIONS OF REJECTION IN FLORIDA (ACTUAL VS. DISCLOSED)

As we can see in that rejection letter above, HIIQ has applied, re-applied, and then filed extended appeals at least 4 times over the course of 2016 and 2017 in order to obtain this license. HIIQ has also hired an expensive law firm in order to try to boost its cause. Yet as the rejection date is now just weeks away, HIIQ has attempted to change its story, suggesting that maybe it just doesn’t need this license at all.

By reading the above rejection letter in full, you will almost certainly come to the conclusion that there is effectively a zero percent chance of HIIQ getting this license in Florida. (Separately, for the sake of completeness, I have sent a copy of this article to the listed email address of the Florida regulator at Carolyn.Morgan@FLOIR.COM).

As we saw above, HIIQ’s disclosure of the Florida rejection was so muted and understated in the 10Q that most investors probably never even saw it. Those that did would have understandably come to the conclusion that it was just no big deal.

Delay, downplay, dismiss, deny.

But the private communications between HIIQ and the Florida regulator were not disclosed to investors. Those statements, IN HIIQ’s OWN WORDS, paint a picture which is absolutely catastrophic.

Below is a screenshot showing HIIQ’s own language (filed by their law firm) describing the dire consequences that HIIQ faces if it is rejected by Florida.

As shown, following its rejection for licensure as a 3rd party administrator in Florida, HIIQ / HPIH wrote a letter of appeal to the Florida regulator dated June 16, 2017. In that letter, HIIQ warned that a rejection in Florida would comprise a “reporting event”, obligating HIIQ to inform the other states in which it does business. In HIIQ’s own words, this would then trigger a “domino effect” which could result in its losing licenses in the other states where it does business. In other words, according to HIIQ itself, the consequences of a regulatory rejection in Florida will be catastrophic.

To say that the interests of HPIH as an entity would be substantially affected is a radical understatement.

Clearly all of this is extremely material information that investors should have been made aware of. But rather than disclose this information to investors, management has dumped over $50 million in stock this year, including just last week.

*** 8 – RESASSUING INVESTORS WHILE AGGRESSIVELY DUMPING SHARES

By now you should start to see what I mean by delay, downplay, dismiss, deny.

Just last week, HIIQ conducted an impromptu conference call to investors, arranged by Craig Hallum. Over the prior two trading days, the stock had dropped from $37 to below $30. But because of this investor call, the stock price quickly rebounded.

As shown earlier in this article, almost immediately after the investor call boosted the stock last week, insiders began quickly disclosing more sales, amounting to $1.5 million across just two days. Sellers included the CFO, the CTO and the CEO of HIIQs Healthpocket subsidiary.

Below is a table showing the insider sales that have occurred just during 2017. A full list of Form 4 filings can be found on Edgar.

During 2017 alone, insiders have raked in $50 million from selling stock. Earlier this year, the entire company a valued at just $200 million. In November of 2016, the entire company was worth just $70 million.

*** 9 – THOUSANDS OF PREVIOUS WARNINGS ABOUT FRAUD AT HIIQ

Realistically, no one needed any legal databases or Bloomberg to figure out what was going on with HIIQ.

Here is a great hint for those of you looking for compelling short ideas. Google the name of a company along with the word “fraud”. Any time you get more than 40,000 immediate hits, you likely have a very safe short. Feel free to try this test with HIIQ before proceeding.

Keep in mind that when parties are accused fraud, they very seldom raise their hand and admit it. The most common response is to put forth repeated denials for as long as possible.

Even before we look at the explicit fraud investigations by 42 different state governments, we can see thousands of very explicit complaints by individual consumers from all across the country.

Regardless of location, consumers across the US repeatedly use words like “fraud”, “scam” and “lies”.

Based on this overwhelming consensus from consumers, HIIQ has actually managed to obtain the ultra-rare “F rating” from the better business bureau.

On the recent investor call, Craig Hallum posed a layup question to HIIQ management, effectively stating, “tell us how bogus and erroneous the BBB complaints are”. HIIQ responded by attempted to convince investors that the BBB is a corrupt entity which has falsely listed more than 80% of the complaints on its site. HIIQ also tried to state that the huge volume of online fraud complaints are simply the result of the fact that HIIQ does a high volume of business, such that a large number of complaints should also be expected.

At just this one site alone, HIIQ has received 651 complaints. Out of the 93 total customer reviews, 90 are negative. This is quite obviously not simply a question of “high volume”.

Yet even aside from the “corrupt” BBB site, every other site I could find also contains very similar fraud complaints from different consumers in different states across the country. The reviews are again overwhelmingly negative, regardless of which site is reporting.

Here is a recent screenshot of multiple consecutive reviews from qn entirely different site called ComplaintBoard.com.

Next, here is the rating page and customer review profile for PeopleClaim.com, which is also separate from the BBB. Again HIIQ receives the ultra-rare “F rating” along with across-the-board ratings of 1 star out of 5 (the lowest rating possible).

Before proceeding further, take a few moments to click on the links above and judge for yourself. When it comes to HIIQ, the caustic consensus among consumers from all across the country appears to be entirely similar regardless of their location.

*** 10 – MY PAST ARTICLES ON “CRAIG HALLUM SPECIALS”

We are currently living through one of the biggest bull markets in history. Stocks of all shapes and sizes continue to surge higher, even on bad news.

Yet somehow I have been able to repeatedly identify dozens of stocks which then quickly imploded by 80-100%. SEC investigations, fraud suits and de-listings followed soon after.

One of my better sources of compelling short ideas (impending implosions) has been stocks which are being aggressively recommended by Craig Hallum despite the presence of very obvious problems.

Each of the stocks below soared by 200-800% following aggressive and repeated recommendations by Craig Hallum.

In each case, the underlying business problems were not only terminal, but they should have been entirely transparent. Not surprisingly, these companies often needed money and Hallum ended up making millions of dollars in investment banking fees across these companies.

For precisely all five of the Hallum trades below, they quickly imploded by at least 30% as soon as I exposed them. They then went on to implode by 80-100%, just as I had predicted.

The repeated theme was that even as the share prices soared ever higher, Hallum would just ratchet up the share price target again and again. After insiders or the companies sold shares, the share price then began its inevitable implosion.

For example, Hallum’s escalating series of buy recommendations helped to take fraudulent Unipixel (UNXL) from $5.00 to over $40. Hallum’s final target before the implosion had been raised to $58.00. After I exposed the fraudulentcompany, the stock ended up getting de-listed and now trades for just pennies. But not before Hallum made millions by helping Unipixel sell shares to investors.

At the time when I wrote about Neonode (NEON), Hallum’s repeated target hikes had seen the stock go from $2.00 to over $8.00. Hallum’s final target was $10.00 before Neonode imploded to $1.00 when Hallum’s predicted business developments failed to materialize. I wrote Neonode when the stock was at $7.00. As I highlighted in my article, prior to the implosion Neonode conducted a huge secondary offering in which nearly all proceeds went to selling insiders.

When I wrote about Erickson Air Crane (formerly EAC), Hallum’s support had seen the stock quadruple to as high as $28.00. EAC was visibly defunct and was being stripped by insiders. On the day of my article, the stock plunged by more than 30%. It quickly went on to implode to zero once it filed for bankruptcy. But not before various insiders unloaded at very beneficial prices.

Plug Power was a very obvious promotion when I exposed it at $8.00. Craig Hallum was again a strong supporter. The company was also in dire need of cash. Following my article, the stock plunged to $1.00, but not before it had already raised $22.4 million from investors.

TearLab (TEAR) was another defunct business in dire need of cash which was being aggressively and repeatedly recommended by Craig Hallum. With the benefit of Hallum’s support, TearLab’s share price eventually reached $18.00. When I last wrote about TearLab, the stock was still at a pre-split price of $13.00. Since that time, the stock has fallen by 99.9% as its nonsensical business predictably failed to materialize. Even after a large reverse split, the stock sits at just $1.00. But as always, TearLab was able to raise large sums of cash from equity sales before imploding.

Please note: There is a very good reason why I have taken the trouble to include these links to my precedent experiences with “Craig Hallum specials”. Please take just a few minutes to read my analysis of these situations, which predicted their obvious impending implosions.

*** 11 – CONCLUSION

I will sum up my thesis on HIIQ as follows:

Delay, downplay, dismiss, deny, then dump millions of stock.

As soon as this latest fluff trade falls into the single digits, you should expect to hear me publicly say “I told you so”.

Disclosure: I am/we are short HIIQ.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Summary

Icahn owns 35% of HTZ and is major Lyft investor. Icahn paying huge premiums to acquire additional targets across rental, ride share, service and parts. “Vehicles As A Service”.

Short interest at HTZ just hit 61.9% of float. Short interest now EXCEEDS effective float by millions of shares. Not enough shares for shorts to readily cover.

As we saw with RH and WTW, shares of highly levered and heavily shorted stocks can quickly triple when even a very mediocre improvement changes the bear thesis.

With Herbalife, Icahn has shown that he iswilling and able to play and benefit from a short squeeze. Icahn is now showing a paper profit onHerbalife of $500 million.

Note: This article is the opinion of the author. The author is long HTZ.

Recent developments

On Tuesday, Hertz Inc (HTZ) released Q2 results. As expected, the numbers were grim as ride hailing services continue to steal customers and revenues from traditional car rental companies. On the conference call, newly installed CEO Kathryn Marinello was making an obvious effort to “under promise, then over deliver”, in sharp contrast to multiple years of unfulfilled hype from her predecessors.

Here is what I suggest. First, read my analysis below. Then go back and re-listen to the Q2 conference call, keeping an ear open for a number of very subtle (and under hyped) clues. Most of these were not even mentioned until the Q&A at the very end:

fleet management, fleet management, fleet management

huge surge in rentals to ride hailing drivers

autonomous vehicles

artificial intelligence

“telematics and car sharing technology”

large increases in ownership by 5% holders

Also on Tuesday, Uber announced that it would be terminatingits car leasing program which was providing cars to Uber drivers with poor credit.

The announcement highlights the need for “transport tech” leaders (including ride hailing and autonomous tech) to focus on what they are good at (i.e. the technology, not the vehicle management). It’s not just that Uber was losing tons of money on this program. The real crisis was the Uber actually had no idea how much money they were actually losing. Uber was originally estimating that losses were running about $500 per car. Instead, the real number was roughly $9,000 per car!

This is why Uber, Lyft, and Apple are already scaling up their programs to use Hertz vehicles and let Hertz handle the fleet management.

Investment summary

Apple, Google, Uber and Lyft have been pouring billions into their quest for ride hailing and autonomous vehicles. Uber alone is on track to lose $3 billion just in 2017 alone. Multi billion dollar losses are just the price of admission into this burgeoning market.

Yet none of these players has any appetite to undertake the ownership, management, repair and logistics of fleet management.

As these giants jockey for position in this transportation gold rush, Carl Icahn is aggressively pursuing the strategy of “selling shovels to the gold miners”.

In various public statements, Icahn has made it very clear that there is a new paradigm shift in how people are getting from one place to another. Icahn is clearly NOT betting that the current car rental model is going to rebound in its current form.

Instead, Icahn is building a nationwide “Vehicles as a Service” (“VaaS”) platform with Hertz (HTZ) at its core. The purpose is to provide fleets and fleet management to the new transportation providers in ride hailing and autonomous vehicles.

Even as Hertz’s share price was plunging to new lows, Icahn more than doubled his stake, buying 16 million more shares at an average of $23.78 in November. Icahn now owns 35% of Hertz.

Over the past 3 years, Icahn has been spending billions, paying huge premiums to snap up numerous other companies from all parts of the fleet management spectrum, including: car rental (fleet management), ride hailing, auto parts and auto servicing.

The headlines over the past 3 years illustrate Icahn’s “Vehicles as a Service” strategy centered around Hertz .

Ultimately, Icahn’s VaaS strategy means that whichever emerging technology wins out in the next few years, Ichan (and Hertz) will be poised to be the most comprehensive and integrated provider of fleets and fleet management.

So rather than being defeated by ride hailing apps such as Uber and Lyft, Icahn is positioning Hertz to be the key service provider to BENEFIT from the rise of Uber and Lyft.

In just the past two weeks we have started seeing industry journals, sell side reports and mainstream media articles which are doing a 180 degree pivot on the outlook for car rental (now known as “fleet management”) providers. Details of these reports and articles are included below.

This new (and more forward looking) thesis is a radical reversal from the draconian extinction thesis which has led Wall Street to place massive short bets against Hertz.

But the extended negative sentiment has already pushed Hertz’s share price down by 90% in 3 years. The most recent “Sell” rating (from Barclays) sent Hertz tumbling by 30% in two days on massive volume. Short interest currently sits at 61.9%.

But in fact it is actually much worse than this.

Beyond the stated short interest on Bloomberg, the true effective float has shrunk to just 22.3 million shares vs. a current 33.4 million shares short. There are simply not enough shares to allow shorts to readily cover. This math and its components are illustrated below.

So how is the bear thesis suddenly changing?

The severe bear thesis has two components, both of which are quite obvious. First, it is assumed that ride hailing companies (Uber/Lyft) will simply put the rental companies out of business by stealing passengers and revenues. Second, it is assumed that rental companies will be severely impacted by a glutted used car market when they attempt to sell their car inventory. This has been a very visible phenomenon over each of the past few quarters (including the just announced Q2).

But now Hertz is gradually being transformed. Rather than being a competitor to Uber and Lyft, Hertz will be a SUPPLIER to Uber and Lyft and will benefit along with their rising dominance. (If you re-listen to the Q2 conference call, this should become apparent.)

Passengers will still be using Uber and Lyft to book rides which are fast, flexible and convenient. But they will be increasingly riding in a Hertz car.

Following his initial investment in Hertz, Icahn invested $100 million in Lyft. Shortly thereafter, Lyft began a program where Lyft now pays up to 90% of the cost for its drivers to rent cars from Hertz, rather than driving their own cars. This allows drivers flexible use of a vehicle whenever they want at almost no cost and with zero responsibility for depreciation or maintenance as long as their rider targets are met. Shortly thereafter, Hertz began a different program to rent cars to Uber drivers as well. Now that Uber has terminated its own leasing program, it will need to figure out a quick and easy substitute (such as Hertz).

When you re-listen to the Q2 conference call, you will hear that there has been a very steep increase in ride hailing rentals, up from nearly nothing a year ago. Virtually no attention was given to this development on the call.

Furthermore, as Apple, Google, Uber and Lyft seek to eventually eliminate drivers completely by using autonomous vehicles, their need for fleet management becomes even more critical (because there will be no more drivers to supply their own cars). Autonomous vehicles are still a few years away. But even as these programs develop in the test phase, they will need fleets of thousands of vehicles across the country.

For Hertz, this new “fleet management” paradigm destroys both legs of the current short thesis. Here is why:

By providing the cars to Uber and Lyft, Hertz will increasingly be able to claw back a substantial portion of the revenues which would otherwise be lostas passengers shift towards Uber/Lyft rather than renting their own cars. Yes, these revenues are lower margin that corporate customers. But they allow Hertz to get marginal revenue from cars which would otherwise be sitting idle.

Second, it also means that Hertz can greatly extend the useable life of its car inventory rather than being forced to dump its inventory at distressed prices into a glutted used car market. “Car rental” customers typically expect a car that is brand new or perhaps one to two years old. But both Uber and Lyft allow their drivers to use cars in good condition which are more than 10 years old. Hertz is already in the late stages of “right sizing” its fleet. Once this is done, the pain from inventory sales should get significant relief going forward.

And as we will see, the Hertz programs with Lyft and Uber are just one element of Icahn’s much wider assembly of fleet management via his VaaS acquisitions.

With Hertz trading down by more than 90% in 3 years, Ichan is now conceivably in a position to acquire the remainder of Hertz outright. The remaining 65% of Hertz’s equity is now valued at just $700 million.

Alternatively, each of Apple, Google, Uber and Lyft are now so enormous that they could easily take a $300+ million stake in Hertz just to secure their future access to the fleet management. Such an investment would be tiny for any of them.

In the past, Icahn has repeatedly taken large stakes in out-of-favor companies which were highly levered and heavily shorted. When his investment reduces the outstanding float of the heavily shorted stock, the supply and demand imbalance causes the shares to rise almost automatically.

As Icahn repeatedly increased his stakes in embattled (and heavily shorted) Herbalife (HLF), that stock rose by 70-100% from the time of his initial investment.

As with Herbalife, Icahn started small and then made a large increase in his stake. Also like Herbalife, Icahn obtained substantial influence over Hertz via multiple board seats.

Hertz is highly levered. Even just a mediocre re-rate of its business prospects (just a slight boost to enterprise value) will result in a massive spike in the equity value. The high short interest will then further turbo charge that rise.

But, in fact, judging by the significant shift among sell side and mainstream media sources, we could be due for a re-rate that is much larger than just “mediocre”.

During 1H 2017, shares of Restoration Hardware and Weight Watchers (WTW) each tripled and quadrupled despite very “mediocre” improvements in their business outlooks and results. The reason for the meteoric share price spikes was that both companies were highly levered and heavily shorted. Again, even just a very mediocre re-rate of their business prospects caused their share prices to triple and quadruple.

Given the significant shift in the business prospects for Hertz, seeing the share price triple or quadruple should come as no surprise in the near future.

This is why Icahn was more than happy to double down at $23.

*** 1. THE BEAR THESIS ON HERTZ HAS REACHED ITS NADIR

Shares of Hertz are now down by 90% in three years. The entire market cap of Hertz is now down to just $1.2 billion. Icahn already owns 35%.

On July 31, Barclays put out an extremely bearish sell note on Hertz. But in reality, all the Barclays note did was simply amplify the bear thesis that had already been widely disseminated in the market for the past year. Barclays predicted that Hertz’s stock was due to fall by a further 50% from its then level of just under $18. In just two days, Hertz stock fell by 30% on 40 million shares of volume. Short interest now stands at a staggering 62.0% of float.

Here are the short interest data:

*** 2. BUT THE HERTZ INVESTMENT THESIS HAS NOW CHANGED

But suddenly, in just the past week, other sell side analysts began waking up to a new paradigm for the former “car rental” companies. These “rental companies” are now being re-cast as “fleet management” plays which are actually CRUCIALto the future ambitions of ride hailing (Uber/Lyft) and autonomous vehicles (Apple/Google).

Hertz share price has been battered due to poor financial performance and negative sentiment towards the future. But this share price outlook could change sharply.

As we have already seen, private companies like Uber and Lyft are being awarded PREMIUMvaluations despite continued large financial losses. The only thing that matters is securing market dominance in this transportation gold rush. Once investors realize Hertz’s emerging positioning in this new market, its distressed valuation could easily flip to a premium valuation.

The only thing that is really necessary is just a change of popular sentiment.

Following the bullish report by JP Morgan last week, mainstream media outletsare now jumping on the bandwagon to hype the prospects of this new distributed transportation paradigm.

A few weeks ago, this sort of positive attention on “car rental” companies was unthinkable. But now such attention is becoming popular.

As Hertz transforms itself into a “fleet management” company, it will let other players (such as Uber, Lyft, Apple, Google) interact with the end passenger. Regardless who is booking the ride for the passenger, the passenger will still end up in a car that is ultimately supplied by Hertz. The transition into autonomous vehicles will only accelerate this trend.

Not only will Hertz get to claw back revenues which would otherwise be lost, but it can also make drastically longer use of its car inventory. Since Uber and Lyft allow the use of much older cars, Hertz can greatly extend the life of its car inventory rather than repeatedly dumping 1-2 year old cars into a distressed used car market.

On August 4th, JP Morgan revealed the first hint of the new investment paradigm from a sell side analyst. Despite his neutral rating on Hertz, the stock jumped 10% that day.

Analyst Samik Chatterjee pointed out that incumbent car rental players would have a distinct advantage over potential new entrants into the fleet management business and that the overlap between rental and ride shares is set to expand:

But actually it was a few days earlier, on August 2nd , that the lead story Auto Rental News was titled: “Own the Fleet, Own the Future”. This article noted that:

In these conversations surrounding new transportation paradigms, fleets have been off the public radar until recently. What those in fleet know, the rest of the world is finally understanding: If you own the fleet, you own the future.

Why? First, a future with fewer personally-owned vehicles means someone will have to own and manage this new ecosystem.

Fleets are playing a part in shared-use scenarios, which were at one time only found in traditional consumer carsharing applications. Using telematics and carsharing technology, these new systems are forming to serve residential and business complexes, downtown offices, universities, municipalities, and whatever type of community needs personal mobility for their members and workers.

JP Morgan notes that the gap between rental cars, ride share and autonomous vehicles is now shrinking, “making them one and the same”.

Hertz already has in place programs to provide rental cars to both Uber and Lyft drivers. In fact, Icahn’s Lyft is now paying Hertz up to 90% of the cost of a rental for Lyft drivers when they meet minimum ride requirements.

What this means is that a Lyft driver can use a Hertz car (rather than his own) at almost no cost. He gets unlimited miles, the insurance is included and he bears no cost of depreciation or maintenance.

Here is the current offer being made to Lyft drivers. Keep in mind that Lyft is the one paying the fully agreed price to Hertz.

Again, remember, Hertz is receiving the fully agreed price for the rentals above. The subsidy is being provided to the driver from Lyft.

*** 3. HERTZ IS NOW THE CENTER HUB OF ICAHN’S “VEHICLES AS A SERVICE” PLATFORM

Ride hailing platforms are undeniably faster, easier, cheaper, more convenient and more flexible than renting a car. So until now, Icahn’s decision to double down on an imploding car rental chain was puzzling. After all, the consensus view on heavily shorted Hertz was that “car rental” is quickly going the way of the Yellow Pages and the printed newspaper. Ultimate failure was certainly viewed as a question of “when” not a question “if”.

So why is Icahn so content with his current paper loss of $1 billion on Hertz?

The answer is that $1 billion is actually a tiny price to pay for a controlling position in the new transportation paradigm. In just 2017 alone, Uber is on track to lose a staggering $3 billion. Eventual profitability for Uber is nowhere in sight.

There are now many players vying for the future of how to transport people around. Giants like Apple, Google, Uber and Lyft have each been competing to throw BILLIONS of dollars into their transportation efforts with absolutely no need to make near term profits.

Regardless of who eventually wins this transportation gold rush, Carl Icahn will be “selling shovels” to them all, winners and losers alike.

Once you review the timeline of Icahn’s involvement in this space, this strategy becomes entirely obvious.

Icahn began investing in Hertz in 2014, when the share price was still over $100. In 3Q 2016, a steep earnings miss sent Hertz’s share price into a tailspin, plunging by 35% from its then level of $35. Icahn immediately bought 16 millionmore shares at an average of $23.78, more than doubling his total stake to 29.3 million shares. Icahn is now the largest shareholder of Hertz with a 35% stake.

Both of Hertz’s bonds and shares have been under tremendous pressure for the past 3 years. Yet Icahn chose to double his stake in the EQUITY, while NOTbuying the BONDS.

If Icahn had any concerns about bankruptcy he would quite obviously be moving up the cap structure away from the common stock and into the bonds. A search of bond holders on Bloomberg shows that Icahn is not a bond holder.

In 2015 (after Icahn had already begun investing in Hertz), Icahn quickly invested $100 million into the ride hailing service Lyft. Icahn chose to take down fully 2/3 of that $150 million financing round in Lyft.

The fact that Icahn chose to invest in privately held Lyft was quite notable. The New York Times observed of Icahn’s investment in Lyft that:

More surprising is Mr. Icahn’s involvement…Mr. Icahn rarely invests in closely held start-ups

Icahn demonstrated that he understands the new ride share dynamic completely.

In an interview with the New York Times, Icahn specifically said of his Lyft investment that:

What I’m saying is there is a secular change going on with the way people are getting around, and with urbanization, it means more people living in urban areas.

So as Icahn continues to ramp up his stake in Hertz, he is certainly NOT doing so because he is oblivious to the emerging dominance of ride hailing platforms. In fact, Icahn is investing in Hertz as a way to benefit from the rise of ride hailing platforms such as Uber and Lyft !

Shortly after Icahn invested in Lyft, Hertz and Lyft began teaming up, creating the above mentioned Express Drive program where Lyft pays to Hertz the cost for drivers to rent cars from Hertz rather than use their own cars. Hertz later began a program for renting to Uber drivers.

In fact, over the past 3 years, Icahn has been paying top dollar across the board to assemble together an interlocking network of automotive companies which will provide rental, ride share, parts, servicing and fleet management.

Pep Boys – Icahn acquired up 130% for over $1 billion

In early 2015, auto parts chain Pep Boys was trading at $8.00. The company was highly leveraged, heavily shorted and financially shaky. (It was quite similar in these respects to Hertz in 2017).

In December 2015, Icahn announced that he had acquired a 12% stake in Pep Boys. Just days later he made a bid for the entire company at $15.50 per share (up nearly 100%). A bidding war ensued with Icahn bidding against Japan tire company Bridgestone. Icahn was more than willing to outbid Bridgestone at $18.50 per share, valuing the company at over $1 billion (up 130% from just a few months earlier). On a standalone basis, most outside observers agreed (at the time) that Icahn significantly overpaid for Pep Boys.

Here was the run-up in the stock leading into the eventual buyout by Icahn.

It took a few months, but finally the media took a completely different view of Icahn’s purchase of Pep Boys.

In 1H 2017, we saw shares of Restoration Hardware and Weight Watchers triple and quadruple from their lows to their highs. Both stocks were highly levered, heavily shorted and faced very visible challenges in terms of business prospects and valuation. In other words, in January 2017, each of Restoration Hardware and Weight Watchers was very similar to where Hertz is today.

For each of Restoration Hardware and Weight Watchers, all it took was a very MEDIOCRE re-ratingof their business prospects to see them triple and quadruple in just a few months.

The meteoric rises of Restoration Hardware and Weight Watchers took everyone (especially short sellers) by complete surprise.

The reason for these wildly disproportionate share price spikes lies in the leverage and the short interest.

High leverage cuts both ways. It amplifies share price moves on the upside as well as the downside. When a mediocre re-rating of the business causes the enterprise value to rise by even just a moderate amount, the high leverage means that the equity value vaults higher by multiples. That is why we call it “leverage”.

Based on the information above, Hertz is due for a truly transformational re-rating of its business prospects. While it was recently dismissed as a dinosaur business on its way to extinction, it is now being viewed as an absolutely critical component of the future of transportation. This certainly merits a more-than-mediocre rise in enterprise value.

Hertz has a total of $16.8 billion in debt. But of this, $11.2 billion is debt secured by vehicles. The debt that really matters to us is the $5.6 billion of non-vehicle debt.

Against this, Hertz’s current market cap is just $1.2 billion, giving Hertz an enterprise value of $6.1 billion

What this means is that as investors re-rate Hertz business prospects, a mere 25% rise in enterprise value translates to a 127% rise in the share price to around $32. If investors decide that the new paradigm makes the business (enterprise value) worth double what the dinosaur was worth, then the share price should go up by 510% to $87.

Clearly this is why Icahn is completely unperturbed showing a tiny little paper loss of just $1 billion .

Against these tremendous upside prospects, it is now the case that there are more shares short than there are available shares to cover in the effective float.

As the share price has fallen lower and lower, more and more bears have piled on at the bottom. The result is that short interest now stands at 33 million shares, which is 62.0% of the stated float (according to Bloomberg).

But it actually gets worse than that. Much worse !

The already staggering 62.0% is the number reported by Bloomberg. But in reality, this number ignores the fact that several funds have initiated, maintained or increased their 5%+ positions and are unlikely to sell in the near term. As a result, these shares are unavailable when shorts are looking for shares to cover.

Furthermore, index funds which own around 18% of Hertz are also unable to sell simply because the share price spikes. They must continue to hold in proportion to their benchmark index weights, regardless of where the share price goes.

As a result, the effective float at Hertz is around 22.3 million shares vs. the short interest which now sits at 33 million shares. There are simply not enough readily available shares for shorts to cover.

Here is the math behind the effective float.

(For a further discussion of the effective float, read my recent article on infinity squeezes.)

Icahn owns 35% of Hertz, which is already being factored in by Bloomberg.

Key funds which each own 5% or more of Hertz include:

GAMCO. Recently increased its stake by 765,100 shares to a total position of 6.6 million shares.

Par Capital. Just initiated a position of 5.9 million shares.

Glenview. Maintained a position of 4.4 million shares.

In total, these 3 funds own 16. 8 million shares that are not being sold, reducing the effective float, making it more difficult for shorts to cover.

Index funds include Vanguard, Blackrock Dimensional and multiple others. In total, index funds own 14.7 million shares. Because they cannot readily sell, they further reduce the effective float, also making it more difficult to cover.

Once we exclude the additional long term funds and index funds, there are only 22.3 million shares in the effective float which is well short of the 33.4 million shares which shorts need to cover.

Here is the HDS screenshot from Bloomberg.

*** 5. ICAHN’S PLAY ON HERTZ VS. ICAHN’S PLAY ON HERBALIFE

Icahn’s play on Hertz is nearly identical to the play that Icahn is making on Herbalife (HLF), in which he is currently showing a profit of over half a billon dollars.

After multiple purchases starting from around $40, Icahn then began seeking permission for larger and larger stakes. In July 2016, Herbalife agreed to allow Icahn to go up to 34.99%. And then in October 2016, Icahn received approval from the FTC to take his stake up to 50%. In February of 2017, as the float was getting tighter and the stock was rising higher, Herbalife announced that it had authorized a share buyback of up to $1.5 billion.

As it applies to Hertz, it is very clear that Icahn is well aware of the short vs. effective float dynamic. And as we saw in Herbalife, he is more than happy to use it to his advantage.

Hertz currently appears quite levered, which has been of concern to investors. But remember that most of that is “vehicle debt” which is secured by the vehicles.

Based on Icahn’s playbook with Herbalife, Icahn could conceivably buy more Hertz stock or use his meaningful presence on the board to encourage the company to authorize additional large share repurchase programs.

Looking back to Hertz…

In June 2016, Hertz announced a new share buyback authorization of $395 million. And then in November 2016, Icahn acquired over 16 million shares of Hertz at an average price of $23.79 for a total cost of over $388 million. This increased his total stake to over 29 million shares (i.e., 126% increase in his holdings).

Disclosure: I am/we are long HTZ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is long HTZ. The author made make additional trades in the next 72 hours.

Summary

Dillard’s appears set up for “infinity squeeze” like VW in 2008, which sent stock up 5x. Einhorn was short VW in 2008, but is now largest outside holder of DDS.

Bloomberg shows short interest at 69.9% of float. But it’s worse. Index funds can’t sell. Einhorn won’t. Short interest now over 100% of effective float.

Aggressive share buybacks (ever after Q1) further reducing float without being noticed. Extent of any further buybacks will be announced in 2 weeks.

Excluding Einhorn and index funds, as few as 4.38million shares in effective float vs. 9 million shares short. I expect further Q2 buybacks of 1-2 million shares.

The math: shorts have now sold millions more shares than they can readily buy back from obvious sellers. Einhorn (or different 3rd party) could recall borrow and trigger massive squeeze immediately.

This article is the opinion of the author. The author is long DDS.

Note: In general I try to link to free data sources so that all readers can evaluate for themselves without data subscriptions. But this article is very numbers-driven, so I have mostly used Bloomberg data. I have included screenshots to show the data where practicable. Other links can be clicked on from various sources, including Edgar. In making my investment decision, I have done my own math and made my own decision. Do your own math and make your own decision.

This trade is about the potential for a massive short squeeze due to a mathematical imbalance. Shorts have sold millions more shares than are readily available for them to buy back. Someone (the last to cover) will be stuck paying an astronomical price.

I am less focused on the fundamentals at Dillard’s. But it is important to at least differentiate Dillard’s from the financially shaky players like Sears (SHLD) or JC Penny (JCP).

The short thesis is simple. Online shopping from places like Amazon (AMZN) is replacing “brick and mortar” shopping at places like Wal Mart (WMT).

But unlike many of the other department stores, Dillard’s has strong free cash flow and little debt. Dillard’s is trading at just over book value. However, book value only values assets at historical cost, which is decades out of date. Market value of Dillard’s real estate has been estimated at $3-4 billion. Even with a generous haircut to those numbers, Dillard’s is still trading at a discount to its real estate value. There is effectively zero visible bankruptcy risk for Dillard’s and significant incentive for the company to go private.

Again, I am not really focused on the fundamentals at Dillard’s. This thesis is about the math that says there are millions more shares short than are in the effective float.

In any event, the numbers above arguably make Dillard’s a better long pick than Macy’s (M), Target (TGT) or Kohl’s (KSS).

But again, this is not a thesis about the fundamentals at Dillard’s. It is a mathematical trade based on the short interest exceeding the effective float.

Below we will see how the short interest somehow became the highest in the retail space.

*** Investment thesis – set up for “Infinity Squeeze”

For those in a rush, I briefly summarize my thesis here. In the section that follows, I include Bloomberg screenshots and additional links to SEC filings so that readers can do their own math.

Dillard’s now appears perfectly set up for an “infinity squeeze” which could be triggered at any time.

The most famous example of an infinity squeeze was that of Volkswagen AG in 2008. When Porsche suddenly upped its stake without prior notice, shares of VW quickly rose by a stunning 5x (more than 400%) within days, making it (briefly) the world’s most valuable company by market cap at €300 billion. Hedge funds suffered estimated losses of as much as €30 billion that week, while Porsche reportedly made a profit of €6 billion.

Clearly size is not a limiting factor with infinity squeezes. (That’s why they are called infinity squeezes….)

As we saw with the VW squeeze, the only thing that matters in an infinity squeeze is when shorts have sold more shares than they can readily buy back in the effective float.

At Dillard’s, short interest stood at just 20% in January 2017. No big deal. But then several things happened.

During 1H 2017, shares sold short rose to 9 million shares. At the same time, accelerated share buybacks by Dillard’s simultaneously reduced the float to just 12.88 million shares. As a result, Bloomberg now reports that short interest has suddenly risen to 69.9% of float. It seems that this “double whammy” of rising short against falling float had escaped the attention of short sellers who should have been paying attention. (Note that many other financial sites have also missed the buybacks. Their numbers for shares outstanding and float at Dillard’s are inaccurate and have not been updated since the 10K was filed. This is another reason why some investors are only now figuring out what has happened.)

Oh but it gets much, MUCH worse than that.

The third leg of this “triple whammy” is this:

Of the 12.88 million share float, as much as 6 million shares are in the hands of index funds (including Blackrock, Vanguard and others) who are typically unable to sell in meaningful size, even when the share price rises sharply. They must generally hold in proportion to their benchmark indices. As I will show below, the inability of index funds to sell their shares was a key contributor to that massive infinity squeeze of Volkswagen in 2008.

A further 2.5 million shares are held by David Einhorn’s Greenlight Capital, amounting to 9.99% of the company. As it so happens, Einhorn was on the painful side of that VW squeeze in 2008. So he can certainly appreciate the short vs. float dynamic that is suddenly unfolding at Dillard’s. (In other words, even if the stock spikes by more than 50-100%, don’t be surprised if Einhorn still isn’t selling.)

With index funds largely unable to sell much of their up to 6 million shares and with Einhorn unlikely to sell his 2.5 million shares, the true “effective float” is really as low as 4.38 million shares of readily and likely available shares for shorts to cover their 9 million shares short.

Wow. That’s really, REALLY bad. But wait, there’s more.

In fact, to the extent that Einhorn has been lending out his shares, he could presumably recall those shares at will. This could force shorts to buy up to 2.5 million shares regardless of price – IMMEDIATELY. And just when shorts are forced to scramble to buy shares, there are simply not enough shares in the effective float to facilitate easy covering. Anyone who is long could simply hold out for astronomical prices and the shorts would be forced to pay. This is what happened with VW and was why Porsche made a €6 billion profit in a single week.

Alternatively, the effective float at Dillard’s is now so tiny that any 3rd party investor could swoop in, buy a block of stock and recall the underlying borrow. Given how tiny the effective float has become, such a strategy would NOT require a huge outlay of capital. Any takers ?

This is just what “Pharma Bro” Martin Shkreli did with KaloBios (KBIO) in 2015, causing those shares to rise by 100x (yes, 10,000%) from their lows to a high of over $44. As a reminder, if a tiny 1% position rises by 100x then your entire fund goes to zero.

With both VW and KaloBios all it took was a single press release or Tweet from the 3rd party investor to spark the infinity squeeze which soared by hundreds or thousands of percent within just days.

As we will see below, prior to their gargantuan infinity squeezes, media sources reported that short interest was at less than 15% for both Volskwagen and KaloBios. By comparison, reported short interest at Dillard’s now stands at 69.9% according to Bloomberg. This shows how vulnerable Dillard’s share price is to such a massive squeeze.

Ok. So it couldn’t possibly get any worse, right ?! Wrong.

It is the ongoing share buybacks by Dillard’s that caused this precarious situation to develop without notice. And with the stock hovering near 5 years lows during Q2, those buybacks have recently beenaccelerating. A lot.

Dillard’s announced Q1 (ended April) results on May 11, 2017. In that press release, Dillard’s announced that it had repurchased 1.7 million shares. This would leave Dillard’s with 26.49 million Class A shares outstanding as of April 29th.

But in the Form 10Q which was released 3 weeks later on June 6th, the share count on the cover page was only 25.178 million dated as of May 27th. This means that 1.3 million more shares were bought back in May (the first month of Q2, which will not be fully disclosed until August 10th).

This 25.178 million share count number was updated on Bloomberg, but it seems that few people noticed the impact that this would have on the float, especially vs. the rising short interest. There was NOT a press release announcing the repurchase of the additional 1.3 million shares.

So during just a 3 week period, investors who had been paying attention should have realized that the float had shrunk by 3 million shares. During this same few weeks, shares short rose by 3 million shares.

This is how we quietly got to a staggering short interest of 69.9% apparently without many people noticing.

In fact, Dillard’s has the cash and the approvals to have been conducting even more buybacks in June and July.

On August 10th, (about 2 weeks from now) Dillard’s will release Q2 results and will reveal how many shares were bought back in June and July.

As a reminder, Dillard’s generated over $400 million in free cash flow last year and has aggressively repurchased shares in each of the past 6 quarters. These buybacks have visibly become more aggressive as the share price has fallen. During Q2, the share price continued to hover near 5 year lows.

I expect that on or about August 10th, we will see that Dillard’s repurchased 1-2 million additional shares in June and July.

If this turns out to be this case, it would further reduce the effective float to as little as 2-3 million shares which would be likely and readily available for shorts to cover their 9 million share short position.

Here’s the rub:

The conceptual risk here is that Einhorn or any third party investor decides to recall stock borrow and force a squeeze when so few shares are readily available.

Einhorn has been gradually acquiring over several years, but his stake is still just under 10%, meaning that he his not an affiliate. So simply deciding to stop lending shares should not be controversial in my view. Likewise, an outsider could end up triggering a squeeze even by acquiring less than 5% of outstanding shares. This would be far less aggressive that what Shkreli did with KaloBios in 2015. Shkreli has come under tremendous scrutiny from regulators and the media for a variety of his past actions. But so far I have not found any mention of the KaloBios squeeze amongst his current regulatory problems.

Either way, even in the absence of such a trigger, I expect shorts to rush to exit their positions in Dillard’s well before the new share count is revealed on or around August 10th. At the same time, I cannot imagine why any longer term holders would be selling prior to August 10th, when the extent of share repurchases is revealed.

*** The math – potential infinity squeeze at Dillard’s

There are 9 million shares short at Dillard’s but there are only around 4 million shares which are likely and readily able to be bought back.

Dillard’s

Shares in the effective float

Float: 12.88 million

Stated float as per Bloomberg

less: 6.0 million

Shares held by index funds (cannot readily sell significantly)

less: 2.5 million

Shares held by Greenlight Capital (very unlikely to sell)

Total: 4.38 million

Effective float = shares readily and likely to be buyable

(Potential for further float reduction of 1-2 million shares due to possible buy backs in June-July could leave as few as roughly 2-3 million shares in the “effective float”. Q2 results and buyback size to be released on or around August 10th.)

At Dillard’s there are 25 million shares outstanding. But 12.297 million shares are “stagnant” in the hands of various insiders (including Dillard family members) and Evercore (which manages the Dillard’s 401K plan).

This leaves only 12.88 million in the public float, as per Bloomberg.

Also as per Bloomberg, there are currently 9.0 million shares short in Dillard’s, which already amounts to 69.9% of this stated float. Number of shares short is up from 3.6 million in January 2017.

Below is the list of holders of Dillard’s stock from Bloomberg. As I see it, the obvious index funds include Blackrock and Vanguard. Dimensional also takes a hybrid index approach. Even funds such as BNY Mellon and State Street have funds that allocate via indexing. Collectively index funds own as much as 6 million shares. A screenshot of the Bloomberg HDS table is also included below.

Note that as of the last reporting dates, 18 out of 20 of these holders INCREASED their positions in Dillard’s as shown on Bloomberg.

But also note that because some of these holdings are reported as of March and some as of June, we there will be some overlap in the holdings across these periods. This will obviously change over time.

As you can see from the HDS table from Bloomberg, Einhorn’s Greenlight Capital increased its stake in Dillard’s by a net 623,675 shares in the past quarter.

(Note: SEC filings show that Greenlight did sell a mere 35,125 shares in June so as to keeps its stake at just under 10% of Dillard’s. When Dillard’s Form 10Qrevealed in June that the share count had shrunk by 1.3 million shares in May, it resulted in Greenlight’s stake briefly exceeding 10%. Greenlight’s tiny sale occurred immediately after that disclosure and took their stake back down to 9.99%. Note that Einhorn’s stake did INCREASE by a net 623,675 shares in 1H 2017.)

The reason I assume that index funds cannot for the most part sell meaningful amounts of stock at will is partly just common sense. They are index funds. But also, we saw in the 2008 infinity squeeze of VW, it was the inability of index funds to sell their shares that contributed to the height of that squeeze that saw the shares rise by 5x within just days.

We know this because as the squeeze was in full effect, German officials quickly stepped in and conducted an emergency de-weighting of VW within the DAX index, allowing these index funds to sell.

By Tuesday night, the establishment was fighting back. Germany’s premier stock index, the DAX, was changed to cut VW’s proportion in it. That allowed index funds to sell stock, adding to the supply of shares, and VW’s shares lost part of their gains.

Greenlight’s average cost basis on Dillard’s is listed on Bloomberg at $78.47. And they have been increasing the position in recent periods. Knowing that, in combination with Einhorn’s experience in VW, I do not expect David Einhorn to be selling just to alleviate an obvious short squeeze (unless we see the share price at much, much higher levels).

After all…why would he ?

So if we decide that index funds either can’t or won’t sell in meaningful size and that Einhorn is also unlikely to sell, there are really as few as 4.38 million shares readily available and likely to be sold for shorts to cover their 9 million shares short.

Next let’s look at the share buybacks by Dillard’s which are rapidly shrinking the float.

Dillard’s has been aggressively buying back stock for (at least) the past 6 quarters in a row.

As shown, in the past 6 quarters, Dillard’s bought back shares as follows:

Date (EoQ)

Value repurchased

Shares repurchased

1/30/2016

$117.5 million

1.6 million

4/30/2016

$58.4 million

0.7 million

7/30/2016

$54.1 million

0.9 million

10/29/2016

$53.1 million

0.9 million

01/28/2017

$80.6 million

1.3 million

04/29/2017

$91.1 million

1.7 million

NOTICE how those buybacks have been getting more aggressiveeach quarter as the share price was falling.

Also NOTICE that the share price during Q2 continued to hover near 5 year lows. This is why I expect that another 1-2 million shares were repurchased in June-July.

These ongoing buybacks (and the reductions in share count / float) were a major contributor to the short interest rising from 20% in January to 69.9% at present.

Just from May through June, short interest rose from around 40% to 69.9%.

Just look at the steep trajectory of the short interest vs. float in the chart below, which took off in January and then accelerated from May through June.

When Dillard’s announced Q1 results (ended April), they also announced that the company had bought back 1.7 million shares in that Q1.

But many people failed to notice that by the time the Form 10Q was actually released in June (3 weeks later), that the share count had fallen by an ADDITIONAL 1.3 million shares, even AFTER Q1 had been fully reported.

In other words, just in the month of May, Dillard’s accelerated its buyback, buying 1.3 million shares in a single month, reducing the Class A share count to just 25.178 million.

Realize that there was no paragraph in the 10Q explicitly spelling out further buybacks during May. It was just a change on the cover page to the number of shares outstanding. That change was quickly reflected on Bloomberg but it seems many people either missed the change or failed to appreciate its significance.

Here is a screenshot from the cover page of the Form 10Q released in June 2017.

(Note: Dillard’s has 4.01 million shares of Class B stock which gives Dillard family members voting control of the company. The Class B shares do not trade. The number of Class B shares outstanding and the ownership by the family members has remained constant going back to at least 2008. The Class B shares have nothing to do with the tradeable float or short interest.)

With the stock price hovering mostly near 5 year lows for much of June and July, I feel that it is safe to assume that across June and July, Dillard’s likely bought back an additional 1-2 million shares, further reducing the effective float. They certainly have the cash flow to do just that.

Further repurchases would also be consistent with their behavior over the past 6 consecutive quarters.

Here is the annual free cash flow for Dillard’s over the past few years. Notice that for the year ended January 2017, Dillard’s generated over $400 million in free cash flow.

In fact, we can see that this pattern of aggressive share buybacks has been going on for years. Ten years ago, Dillard’s had roughly 60 million shares in the float. That has since fallen by nearly 80% to 12.88 million.

So given the chart above, choose which of the following scenarios would surprise you more:

Scenario A.After more than 10 years of aggressively buying back billions of dollars worth of its own shares, Dillard’s finally acquired all shares and took the company private when the stock was near 5 year lows.

Or…

Scenario B. After more than 10 years of aggressively buying back billions of dollars worth of its own shares, Dillard’s suddenly stopped buying when the stock was near 5 year lows.

You can decide for yourself. But while you’re thinking about it, also consider this.

Whatever Dillard’s is theoretically “worth” as an entity, that value is increasing sharply on a per share basis as a result of those buybacks.

Some investors may look at “free cash flow per share” others may want to look at “book value per share” to approximate the estimated $3-4 billions of dollars in real estate that Dillard’s owns. Either way, on a per share basis, any per share number is increasing sharply due to the buybacks.

Obviously reported “book value” will be very out of date because it only reflects the cost at the time the real estate was acquired in past decades. The market value of the real estate should certainly be much higher than book value. But just to get an idea of the impact of the buybacks on book value per shares, here is the chart from Bloomberg.

Anyone who is short Dillard’s need to factor this rising value per share into their target prices.

Here is one presentation that valued Dillard’s real estate at as much as $6 billion. I am not really trying to take a guess at that number. Instead, I am satisfied that even with a substantial haircut to that number, the current value of Dillard’s real estate ALONE is still well above Dillard’s market cap. (And that ignores the ≈$400 million in free cash flow.)

*** What could actually spark an infinity squeeze at Dillard’s (like, as in RIGHT NOW) ?

Just prior to the 2008 infinity squeeze on VW, short interest at VW had been reported at just 12.9% of outstanding, which did not seem alarming. For Dillard’s, the reported short interest on Bloomberg was only 20% in January, but it has already risen to 69.9% as of now. That is absolutely alarming.

Remember that Einhorn was on the painful side of the 2008 infinity squeeze on Volkswagen. Shortly after the VW squeeze, Einhorn’s subsequent investor letter revealed some valuable lessons for those caught in such a squeeze on how they can live to fight another day rather than going down with the ship.

I strongly suggest that anyone who is currently short Dillard’s read that quote from above. And then go back and read it again.

Focus on this part:

The worst trade is the one you don’t want to make, but the one you have to make…..we are unwilling to risk the entire portfolio on a single investment….Though VOW was not a large position on Friday, it became one by Tuesday.

The now-tiny effective float means that even aside from Einhorn there is now a very real possibility that a different 3rd party could swoop in and ignite a similar squeeze by simply buying a small chunk (less than 5%) of the stock and then recalling the borrow underneath it. Such a strategy would NOT require a huge outlay of capital.

This is exactly what Martin Shkreli did in 2015 when he bought shares of KaloBios and recalled the borrow. Shares of KBIO quickly skyrocketed by 100x (yes, nearly 10,000%) from their lows.

The table below shows the 100x rise in KaloBios’ share price following the announcement of Shkreli’s purchase on November 18th.

Note carefully that the share price had been rising sharply in the days leading up to that announcement. And that KaloBios’ share price quickly soared by 10,000% to a high of more than $44.

LOOK at the dates. and then LOOK at what the prices did in percentage terms. When these squeezes happen, they are sparked immediately overnight and then continue squeezing for many days.

This is what Einhorn meant about “unwilling to risk the entire portfolio on a single investment” and “not a large position on Friday, it became one by Tuesday”.

As you can see above, the squeeze unfolded over multiple days as certain investors tried to “wait it out”, thinking that the stock would have to come back down once the “weak shorts” were flushed out. It turns out that the ones who covered early were actually the ones who made it out with the least damage from this 10,000% rise in just 7 days.

The infinity squeeze on KaloBios was made more memorable by retail trader Joe Campbell who started a GoFundMe account to seeking contributions after his $37,000 account lost nearly 400% of its value overnight, leaving him over $100,000 in debt to Etrade. Campbell had been short the stock at around $2.00 at the close on November 18th, prior to the announcement on Shkreli’s purchase.

But Shkreli wasn’t content with the rise from $2.00 to the $20s. He wanted more. And any time we see a mathematical imbalance of shares short vs. effective float, this goal becomes very easy to obtain.

On Thanksgiving day, Shkreli put out the following tweets, sending the stock as high as $45 (up another 73% in a day) when markets reopened on Friday. KaloBios’ stock had been at just 44 cents 10 days earlier.

Notably, short interest at KaloBios just prior to the squeeze had been reported at less than 10%. Obviously this is far lower than the 69.9% we see reported at Dillard’s.

Regardless of what anyone thinks about Dillard’s current share price, it is hard to deny the fact that the stock is now extremely vulnerable to a potential squeeze play by an outside investor, similar to what Shkreli did with KaloBios.

So again, here is the math as I see it with Dillard’s:

There are as few as 4.38 million shares which are readily able and likely to be sold by existing holders. But there are 9 million shares short which need to be bought. This situation is already very bad, but it could get dramatically worse in just an instant in a single day if anyone chooses to recall borrow or acquire any meaningful new stake.

I expect this aleady-bad situation to get much worse on August 10th when we learn just how many shares Dillard’s bought back in June and July.

Again, I am expecting to see additional repurchases of up to 1-2 million shares, which would reduce the effective float to as low as roughly 2-3 million shares even as the number of shares short sits at 9 million which must be covered.

Given the cash flow, the real estate and the aggressive buybacks at Dillard’s, a short bet on the stock was already not a particularly bright one in the first place. But given the rate at which the float is disappearing and the potential for an ignited infinity squeeze, staying short Dillard’s now is just plain lunacy.

Do your own math. Conduct your own analysis. Make your own decision.

*** The shorts aren’t dumb – so how did we get here ?

Here is the way I see it.

A major contributor to this infinity squeeze setup is just the fact that Dillard’s does not appear to be a “conviction short” for anyone. As far as I see, no one is shorting Dillard’s simply because of a view on Dillard’s. Instead, there are many funds taking small positions of 50-100 bps in each of multiple department stores as part of a vey generic sector short on retail.

As recently as January, the short interest in Dillard’s still sat below 20%. It wasn’t really that bad. Yes, the number of shares short at Dillard’s steadily increased. But so did the number of shares short for most department stores. Hedge funds were just spreading their bets around.

With Dillard’s, there has been a “triple whammy” which caused a sharp change in the short interest relative to the effective float changed. The sharp change happened fairly quickly without anyone noticing until it was too late.

Here again is the triple whammy.

The float was already quite low at Dillard’s. This meant that the stock buybacks by Dillard’s had a disproportionate impacton the remaining float. As the float continued to shrink, the significance of the position held by Einhorn and the index funds grew quickly and exponentially. But because Dillard’s was just part of a larger generic sector short for hedge funds, this dynamic was missed by those who were going short. For most investors, their short positions were just too small to merit significant individual attention. Since January 2017, hedge funds steadily increased their short bets against a wide variety of department stores. But with Dillard’s specifically, they were increasing a short bet against a disappearing float and against an effective float that was shrinking even faster (due to the impact of the buybacks).

And now there there are millions more shares short than are in the effective float which can readily be bought back.

Disclosure: I am/we are long DDS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is the opinion of the author. The author is long DDS. The author may make subsequent trades in various securities mentioned in this article within the next 72 hours.

Debt: ≈$500 million plus $132 million in put liabilities to JV doctors

Borrow: At least400-600k shares (up to $10 million)

Borrow fee: 0.90%

Options: Calls and puts

Overview

Right now shares of American Renal Associates (ARA) are trading for around $17. If things go “better” than expected, then I expect that the shares may “only” fall to around $7 (down 60%).

But in reality, a more likely scenario in the foreseeable future is actual insolvency for this troubled dialysis provider. If that view sounds extreme to you, then just read on. I think you will see clearly what I mean below.

As I will repeat throughout this article: Do not believe me. Do not believe the sell side. Instead, look to ARA’s JV partners (insiders) who are now exercising their put options nearly as fast as they can possibly vest them.

In the past, my articles on multiple private equity backed IPO’s ended up quickly presaging declines of 70-100% for stocks like IRG and Erickson Air Crane (among others). With Erickson, the stock fell as much as 30% on the day of my article. But the pain was actually just beginning. The stock went on to be a true zero and quickly ended in bankruptcy.

But as I will show towards the end of this article, an even better template for ARA is the bankruptcy and implosion of Adeptus Health (ADPTQ).

** Parallels between ARA and Adeptus too obvious to ignore **

Here are just nine obvious ways in which ARA looks like an identical replay of bankrupt Adeptus which quickly fell from $120 down to $1.

Just to make things simple, I will number the most obvious similarities.

Adeptus was 1) a private equity backed 2) healthcare services IPO which 3) surged after it came public only to see 4) its results falter amid 5) overpayment issues which were 6) exposed in news reports over its 7) problematic business model. 8) Despite the emergence of obvious problems, the sell side banks were more than eager to hype the stock (and at Adeptus were then more than willing to accept the banking fees from the huge share sales by Adeptus’ private equity backer). 9) Numerous hedge funds naïvely piled into the stock. Just like ARA, Adeptus’ public problems began with a simple newscast revealing the problems with overcharging. Even until the bitter end, and despite the increasingly obvious problems, analysts were telling investors that Adeptus was a “buy buy buy”.

Adeptus soon filed for bankruptcy and the stock now trades for around $1.00 with the dreaded “Q” added to its ticker. Down more than 99%.

The key to understanding the short thesis on ARA is understanding why the nephrologists (ARA’s joint venture partners) are suddenly rushing to exercise their put options on the business, requiring ARA to buy them out of predetermined equity stakes.

As part of the JV structure, ARA grants to the clinic operators (nephrologists) put options allowing them to force ARA to repurchase a predetermined portion of their equity stakes. The total size of this put liability for ARA is currently $132 million, however most of these options are not currently vested or able to be exercised. There are a total of $36 million of “event based” puts which are not exercisable until the occurrence of certain future events. The other $94 million of these puts are “time-based” put options which become only exercisable after certain specified dates. For example, over full year 2017, $23 million of these time based puts will become exercisable by the end of the full year.

These nephrologist partners are the ones who actually operate the dialysis clinics on the ground, such that they understand the business better than anyone.

Better than ARA, better than investors, better than sell side analysts.

In fact, these JV partners have now suddenly begun exercising these puts and selling their equity in ARA nearly as fast as they can, cashing out as much as 50-80% of all vested time-based put options in a given quarter. This is a very recent and sudden development and is unprecedented in the history of ARA. As new troubles have begun to hit ARA.

These JV partners recently exercised more puts in a single quarter than had been exercised in the entire cumulative history of ARA.

But in conveying their optimism for ARA, sell side analysts have completely ignored this surge of JV partners suddenly cashing out as fast as they can.

What investors need to see is this: not all of the put options are currently vested. Only a small portion can currently be exercised. Of that small portion where they actually CAN exercise, the JV partners ARE exercising nearly everything they can as fast as they can.

In other words, it is not the SIZE of the total exercises, but rather it is the RATEthat these puts are being exercised as soon as they vest.

So the question is WHY are these JV partners rushing to cash out as fast as they can ?

My short answer to “why” doctors are cashing out is this: Following the slow unraveling of the “charitable assist” model towards Medicaid patients in 2016 and the ongoing “patient steering” fraud lawsuit, ARA’s commercial revenue mix is falling much faster than expected. This is important because commercial payors have historically reimbursed at roughly 4x the rate of Medicare/Medicaid (or even more). The JV partners can clearly see this sea change in reimbursement on the ground, in complete contrast to the continued “hopes” expressed by analysts. In addition, ARA’s commercial mix has historically been elevated to a much higher level than competitors such as DaVita. As the practice of “premium assist” continues to come under ever greater pressure, ARA has much further to fall than DaVita. Because more than 100% of ARA’s profits / EBITDA come from just the 14% of commercial mix, ARA is truly hyper sensitive to even a tiny drop in the commercial mix. ARA’s remaining 86% of revenues are deeply unprofitable. On a recent conference call, ARA quietly mentioned that going forward it would only be disclosing commercial mix on an annual (not quarterly) basis. Investors will therefore now have a 1 year lag behind what the JV partners know regarding the commercial mix. Furthermore, compared to DaVita, ARA is heavily and uniquely over-exposed to the JV/Put model, such that individual doctors will end up competing with one another to be the first to get their money out of heavily indebted ARA. So this is why the doctor / JV partners have been rushing to exercise their puts as fast as they can. More details below.

** The big question for investors **

As we will see below, the overall size of the put liability and exercises is NOTcurrently enough to sink ARA by itself. Instead, the sudden and rapid exercise of the puts by the JV partners is just signal of what these on the ground participants know that the rest of us do not.

The biggest question investors should ask themselves is this: If ARA’s JV partners are rushing to SELL their puttable equity stakes nearly as fast as they can, then who on Earth would be foolish enough to BUY ARA stock at the same time ?!?!

As investors start to figure this out, this is why I expect significant near term downside to the stock. Simply no one should be foolish enough to step up and buy ARA at anywhere near current prices.

** JV put exercises – how sudden ? how steep ? **

Looking more closely at this surge in put exercises, as of ARA’s IPO prospectus in April 2016, the company disclosed that:

Since our inception, only $5.8 million of time-based puts have been exercised by our nephrologist partners.

(Note that this equates to just $0.96 million per year since inception.)

Then starting at the beginning of 2H 2016, ARA was hit by a wave of negative articles from the New York Times along with a fraud lawsuit by United Health describing “fraud” and “patient steering”. The fraud lawsuit was then followed by even more negative actions in August from the Department of Health and Human Services which explicitly sought to curtail such “steering”.

By September of 2016 (immediately after these problems became public), we saw that the nephrologist partners very suddenly began exercising their put options almost as fast as they could even vest them. Anyone watching this should have viewed is as a very drastic about-face vs. the prior 6 year history of ARA. It was unprecedented.

As of Q1, these nephrologists have already exercised more than $12 million of these puts just since Q3. This more than double what had been exercised in the entire prior 6 year cumulative history of the entire company !

The point is this: on the surface $12 million doesn’t sound like a massive number by itself. And this is why analysts and investors have ignored the significance of it.

But more important than the SIZE of the liability is actually the RATE at which these doctors are exercising their puts. Not all of the equity is actually subject to put provisions. The point is this: for the portion which IS subject to put provisions, doctors are now exercising as much as 50-80% of all vested options in any given quarter. This has continued into Q1 more recent events now suggest that it will accelerate into Q2.

The JV partners are rushing for the exits nearly as fast as they can. The only thing slowing them down from taking out more of their money is the vesting schedule which is staggered over time.

Obviously this is a very stark contrast to what was disclosed by ARA in the IPO prospectus.

For example, as of the end of Q2 2016, only $15.5 million of these time-based options were exercisable for the entire remainder of 2016 (two more quarters). But, as shown in “purchase of non controlling interests”, the nephrologist partners immediately exercised $8.1 million in Q3 alone, immediately after the bad news began to hit (more than 50% of vested options for 2016 exercised in just a single quarter).

For all of 2017, there are only $23 million in time-based puts which become exercisable over the course of the entire year. Yet in Q1 alone, the JV partners had already exercised $4.5 million in just that first available quarter, as shown in “purchase of non controlling interests”. This is therefore on track for nearly 80% exercise of all vested options once they actually become vested over the course of 2017.

And also keep in mind that there are also an additional $36 million of “event-based” puts which are triggered by separate events and which are not part of this “time based” vesting schedule. Once these become triggered and vested, JV partners can then start selling those equity stakes as well.

This sudden urgency to exercise vested puts tells us that the problems facing ARA are very real. And it is being conveyed to us by the local nephrologists who know the business even better than ARA itself. (Certainly far better than analysts and investors.)

** And then there’s that $500 million in debt **

The insolvency case for ARA is all the more likely due to the $500 million in debtthat ARA has taken on. ARA recently extended the maturities of its debt, so any insolvency is not going to happen overnight. But the purpose of this huge levering up, of course, was largely for the simple purpose of just handing out large cash dividends to its private equity backer / shareholder.

As we saw with Adeptus, once PE firms get their first payouts via debt financed dividends, I frequently see them start banging out equity offerings regardless of price. By the time they are playing with “house money” it matters much less if they sell at $10 or $20, (or even $5). In all scenarios, life is good.

** Negative developments that spurred put exercise (2016- 2017) **

The first wave of negative developments for ARA began in mid 2016. By now these first wave developments have been widely disseminated and are well understood. These developments from 2016 are not, not, NOT part of my short thesis on ARA ! But they do need to be understood for context. After that, we can look at newer (2nd wave) developments in 2017 over just the last few weeks which have been missed by the market.

Developments from 2016 included a series of scathing articles in the New York Times specifically naming ARA and a lawsuit against ARA by United Health (alleging millions of dollars in fraudulent “patient steering”).

It appears that the lawsuit filed by United Health may have been deliberately overly broad. Although the suit was filed in Florida, it included United Health Ohio as a plaintiff in addition to United Health Florida. The suit also named an ARA holding company in Massachusetts which has no presence in Florida.

In fact, the strategy by United Health appears to have been pure genius. Not surprisingly, the subclaims including United Health Ohio and the ARA holding company were both dropped or dismissed. Those outcomes should have been entirely obvious in advance. The remaining fraud suit of United Health Florida vs. ARA continues to be ongoing.

The genius part is that United Health achieved a near immediate launch of multiple federal investigations into the allegations of fraudulent patient steering.

I STRONGLY encourage readers to view the entire fraud complaint by United Health against ARA. It contains a detailed explanation of the “patient steering” allegations along with a wealth of detailed numbers and data regarding Medicare, Medicaid and commercial reimbursements and other data which are otherwise very difficult to find.

The New York Times began covering the allegations of steering immediately after the lawsuit was announced. And within weeks, the US department of Health and Human Services initiated a ruling to stop the patient steering which it said had been evidenced by “social workers, health plans, patients, and other stakeholders”.

The government deal cited by the New York Times refers to the promises that AKF had made in order to avoid violating federal anti-kickback laws.

In January 2017, the HHS ruling was stayed by a Texas judge (on procedural grounds only, not on its merits). Some analysts and investors then hoped that ongoing damage to the dialysis players could be mitigated.

In January 2017, federal scrutiny intensified further, into a second federal agency when the US Attorney’s Office sent out subpoenas to numerous dialysis and drug companies as part of its investigation into “charitable” premium assist. This included ARA.

The subpoenas certainly have not been lost on the JV partners. This too has been disclosed and is well known. But the surge in put exercises that followed the subpoenas into Q1 2017 has been totally ignored by analysts and investors.

** Brand new developments in past several weeks (May-Jul 2017) **

More recent developments (which came to light only AFTER Q1 was reported by ARA in May) have been either totally missed by analysts and investors or not fully understood in the context of ARA.

The first wave of developments in 2016 already led to unprecedented cash outs by ARA JA partners via their put options. And now, recent news over just the past few days and weeks appears to be far worse for ARA. When Q2 is announced in a few weeks, we will then be able to see the impact on ARA’s financials and additional put exercises.

These newest negative developments for ARA include newly revealed policies by national commercial insurers to outright refuse premium assist payments from “charities” such as the American Kidney Fund (“AKF”).

For ARA, the impact of this will be a shift in patient mix, which is in fact a double whammy. There will be a decrease in lucrative commercial patients who will be switched to money losing Medicare patients and an increase in loss making Medicare patients. Rather than receiving around $1,000 from commercial insurers, ARA would instead receive $200-250 per treatment from Medicare. The cost to treat patients ranges from $300-400.

Although the shift in reimbursement practices has not been widely reported, ARA’s JV partners would have seen this in practice long before anything would appear in the media.

Notice of these new insurance developments just began in May 2017 (after ARA announced Q1), but was initially limited to specialist dialysis industry journals. Until just the last few weeks, there had been no mainstream coverage that I can find, so this has not been widely known.

But in just the last few days, new headlines have begun to emerge showing that insurers in multiple states are now refusing to accept premium paymentsto insure dialysis patients who already qualify for Medicare/Medicaid and should not be on private insurance.

In addition, by looking at the following quote from DaVita to a specialist dialysis industry journal, we can see that the insurance crackdown is now a) stemming from multipleinsurers and is b) affecting multiple types of policies (both ACA and non ACA).

So far, most insurers engaged in this activity are only targeting patients on individual (or ACA) plans,” DaVita said. “Recently, however, we have seen the first example of an insurance company trying to use the same tactics to push patients out of their Medigap plans.

In June 29th (just 2 weeks ago), we then saw an escalation of the federal investigations into “premium assistance charities” reported on Bloomberg. These charities are the ones operating the model that drug makers and dialysis providers have been using to receive vastly elevated vastly commercial reimbursement. The various investigations and actions by the federal government into this “charitable” activity have now extended into their 3rd federal agency: now including the US Attorney’s Office, the Department of Health and Human Services and (most recently) the Internal Revenue Service.

The recent IRS case focuses on the Chronic Disease Fund, an industry funded “charity” which channels payments from drug makers to support co-pays. This model is effectively an iteration of the same model used by the American Kidney Fund, which is supported by the dialysis industry, including ARA.

In fact, all of this comes on top of new and onerous advances in statelegislationin May 2017 to regulate dialysis providers, imposing mandatory staffing (labor) levels for techs and nurses in dialysis clinics. ARA is not overly exposed in California, but just like the minimum wage hikes that started only in California, this legislation has the potential to spread more broadly to other states.

** The future of “charitable assistance” and its impact on ARA **

After all of the drama and exposure over “patient steering” in 2016, in Q1 ARA suddenly disclosed that it had stopped “assisting” Medicaid eligible patients in securing private commercial insurance via AKF.

Following the ballooning accusations of “patient steering” fraud in 2016, the reason for this change by ARA is quite obvious.

Medicaid pays for 100% of a patient’s costs and requires virtually zero out of pocket to the patient. When a provider such as ARA “assists” these patients into commercial insurance policies, it clearly provides zero benefit to the patient and serves only to quadruple the reimbursement to ARA (or more). This switching of Medicaid eligible patients is visibly indefensible. And that is why ARA had to stop doing it. As a result of this factor alone, ARA’s commercial mix immediately fellby more than 2%.

But dialysis providers, including ARA, continued to assist Medicare (as opposed to Medicaid) eligible patients in getting into commercial policies. Commercial (non Obamacare) patients accounted for 13% of revenues is 2016, but ARA recently disclosed that even this would now drop by a full percentage point in 2017.

Up until recently, industry-funded “charities” have spun a great story about how they help patients. But with three separate federal investigations / actions underway, everyone should start to realize that this “charitable” (industry funded) premium assist racket is likely going to be greatly curtailed or could even go away completely. The mechanics of this scheme are simply becoming too transparent.

Here is how the “charity” racket has worked to date:

As I look at the IRS and other cases, “charitable” assistance allows the providers to channel small amounts of money, using certain “charities” as a “conduit”, to just pay the small premiums and co-pays for patients in order to obtain full insurance reimbursement.

Yes, this certainly appears to be giving support to poor and vulnerable patients. And that all sounds great. These companies and the charities publicly remind us of their public service in every chance they get via press releases and public statements.

But in fact the tiny payments of premiums and copays, sourced from the providers themselves, yields tremendous profits when insurers or CMS are forced to foot the bills for their drugs or services. After the “charity” pays these small co-pays and premiums, the massive reimbursement ultimately flows right back to the providers who made the “charitable donations” in the first place.

Got it ?!

(As an illustration: In the case of dialysis, Medicare/Medicaid only pay the clinics around $200-250 per treatment. But with private commercial insurance, these clinics can get reimbursed up to $1,000 for in network and up to $4,000 for out of network. In other words, the dialysis providers can get from 4-20x the reimbursement rate for providing the same exact services to the same exact patients. Many very poor dialysis patients can’t afford private insurance, so the American Kidney Fund pays their premiums for them. The AKF is overwhelmingly funded directly by the dialysis providers, such as ARA, who then receive the 4-20x reimbursement. Hence the tremendous incentive to “steer” or “assist” these patients into private insurance.)

In fact, the real beneficiaries of these “charitable” activities are actually the drug makers and dialysis providers themselves as a result of the tremendous payments they rake in from private and government payors who are on the hook for these elevated treatment costs.

But now, as we are seeing in recent weeks, the jig is up. Insurance companies and the federal government are now pushing back aggressively against this nonsense in all directions and all at the same time.

Given that many of ARA’s remaining commercial patients are still receiving premium assistance, there is still plenty of further damage to be done to ARA’s financials once these patients get transitioned to Medicare.

** Impact on ARA – why JV partners are suddenly freaking out **

Even into Q1, JV partners were rightfully exercising their puts largely as fast as they could, to get whatever money is obtainable as soon as they can. Given the new developments in May-July, I can only expect the put exercises to accelerate into Q2.

Media coverage of new problems has been building in recent weeks, but has still been relatively limited. Although investors and analysts are still in the dark, the on the ground JV doctors have had full visibility from the clinic level. JV partners have first hand knowledge which is far greater and earlier than any media coverage. This should become even more evident when ARA releases Q2 results in a few weeks.

Shareholders who figure this out will certainly follow the example of the nephrologist JV partners and sell sooner rather than later.

It all comes down to ARA’s hypersensitivity to commercial revenue mix. This is what the JV doctors know far better than anyone else.

First look at this:

For Q1 of 2017, ARA’s revenue increased by 3% and the number of treatments performed increased by 10%. That sounds good right ?

But ARA’s reported adjusted EBITDA figure DECREASED by 22% from $27 million to $21 million. How is this possible ?

Prior to Q1, 17% of ARA’s patients were on commercial insurance vs. 83% on government paid reimbursement plans such as Medicare / Medicaid. (13% were commercial non ACA, while 4% were commercial ACA patients).

In fact, for every patient who uses government insurance (the 83%), ARA actually losessubstantial money. But no worry, the rate charged to private insurers (just 17% of patients) is so high that it makes up for all of the losses on the 83% and then provides ALL of the additional profits to the entire business (more than $100 million in EBITDA).

Following the exposure of ARA in the New York Times articles, the United Health lawsuit and the HHS actions, something interesting then happened at ARA between year end and Q1.

By Q1, ARA’s commercial mix dropped to 14% from 17%. This was largely due to the company’s stated “decision” to stop “assisting” patients into private insurance and out of government programs. Most of the drop was due to the cessation of “assisting” Medicaid patients into private insurance.

But a mere 3% drop is no big deal, right ?! Wrong !

Hypersensitivity:

Note that even though total revenues and total treatments increased during Q1, this tiny 3% drop in “commercial mix” caused ARA to lower EBITDA guidance by $25 million for 2017 – a 20% drop from previous guidance.

Because of the hypersensitivity to very small changes in these variables, analysts and investors have completely missed the going forward impact on ARA.

(But clearly the JV partners have not missed this at all.)

** So why is ARA so much worse off than DaVita ? **

It is worth observing that somehow ARA had historically been able to secure a commercial mix that was as much as 7 percentage points (more than 40%) above where DaVita has historically been, providing a dramatically higher slug of that super profitable commercial revenue. But as a reminder, ARA has publicly denied that it was not engaged in any fraudulent steering of patients into commercial policies.

While ARA was able to hit a 17% commercial mix in 2016, DaVita has historically averaged around 10-11%, only once hitting as high as 12%. So to the extent that ARA’s 17% number “normalizes” along with further changes to the “charitable” assist model, I expect to see at least a further 3-6 point DECLINE in this commercial mix for ARA going forward. And that is certainly at a minimum.

So you do the math. As we saw above, a 3 point change immediately shaved 20% off of EBITDA. Next we can expect a full impact that is double to triplethe original amount.

And keep in mind, as DaVita and other industry players see further declines in commercial mix due to new policies and practices from insurance and the government, ARA should also experience further additional declines in commercial mix as well (even below the 10% level). Investors should therefore not be surprised if EBITDA is cut in half.

A statement from DaVita’s recent conference call was then picked up by the StateOfReform website, highlighting the multiple headwinds and risks that are now affronting dialysis players from all sides.

[T]he concentration of profits generated by higher-paying commercial payor plans for which there is continued downward pressure on average realized payment rates, and a reduction in the number of patients under such plans, which may result in the loss of revenues or patients, and the extent to which the ongoing implementation of healthcare exchanges or changes in regulationsor enforcement of regulations, including but not limited to those regarding the exchanges, results in a reduction in reimbursement rates for our services from and/or the number of patients enrolled in higher-paying commercial plans[.]

In describing the “patient steering” scheme, StateOfReform said this:

The scheme that led to activity at multiple federal agencies is more problematic than improper 3rd party payments. It included enrolling people eligible for Medicaid and/or Medicare onto private insurance — at no cost to the patient thanks to the 3rd party payment — because private insurance, including in the individual market, reimburses at significantly higher rates than government programs. Same patient, same treatment, much higher reimbursement to the dialysis provider.

But again, please keep in mind that my opinion on this really doesn’t matter. Nor does the opinion of the sell side.

It is the opinion of the JV partners that matters. And their opinion is being loudly expressed by their sudden and ongoing rush to exercise their puts as fast as they can.

After multiple quarters of record put exercises, the further put exercises in Q2 should make this clear beyond any doubt.

** So why haven’t investors and analysts figured this out ? **

There are several reasons why analysts and investors have completely missed what is going on here and just how bad it is.

First, the JV/Put model is somewhat complicated. There is JV equity that is owned by ARA corporate (and therefore ARA shareholders), there is separate equity owned by the JV partners (local doctors). Some of the doctors’ equity is subject to puts, while some of it is not subject to puts.

The point is that for the equity which is subject to put provisions, the JV partners are exercising nearly as fast as they possibly can. With the remaining equity, there is just nothing they can do about it.

In ARA’s filings, there is certainly no disclosure which describes anything bluntly as “put exercise by the JV partners who are rushing for the exits”. And again, this is why the sell side can conveniently ignore it.

Instead, the ongoing filings just include an item called “purchase of non controlling interest” which does not sound particularly ominous. Fuller disclosure of the put liability was originally included in the IPO prospectus, but that was in April 2016, prior to any meaningful exercises by the JV partners.

The IPO prospectus stated that:

If the put obligations are exercised by a physician partner, we are required to purchase, at fair market value, a previously agreed upon percentage of such physician partner’s ownership interest.

Along with

We may be required to purchase the ownership interests of our physician partners, which may require additional debt or equity financing

The second reason that analysts have ignored this surging put exercise is that the nominal size of the put exercises appears relatively small relative to ARA. But again, this is a question of hypersensitivity which they have missed.

Our complacent analysts may just view this $12 million as not being big enough by itself to have its own meaningful financial impact.

But it is not the financial impact of these puts that matters. What matters is that it shows that the JV doctors are cashing in whatever vested equity they can nearly as fast as they are possibly permitted to do so.

With 50-80% of all vested options suddenly being exercised in any given quarter, and when that percentage is going straight up over time, this truly reflects a rush for the exits by the JV nephrologists on the ground.

Again, in the 6 years prior we had seen a cumulative total of $5.8 million in puts exercised. Since the September quarter alone we have already seen double that, and the exercise rate vs. vesting appears to be accelerating.

It is these JV partners who know that business better than anyone else. And they seem to be selling as fast as they can.

** What do the analysts say ? **

Are these analysts actually even trying with ARA ? No, they are not. Here’s how we know.

So far there has been no notice from the sell side that these JV partners are suddenly exercising their puts as fast as they can, or that in a single quarterrecent put exercises exceed the cumulative total exercised since the inceptionof the company !!

Instead sell side analysts are doing the same thing with ARA that they did with Adeptus. They are simply pitching hope that the worst impacts on commercial mix are now hopefully “behind the company”.

Because of ARA’s exclusive JV model, the accounting is moderately complex. It involves accounting for a minority interest which fluctuates every quarter along with JV liabilities valued according to opaque “Level 3 Inputs”. More than 40 entries are included in the equity table to reconcile the NCI’s. There is even more, but you get the point.

If the analysts actually wanted to provide proper coverage on ARA, it would require a substantial amount of work each and every quarter. The complexity means that we would expect to see a wide spread in their various price targets and assumptions between different analysts.

But in reality, ARA is just an “also covered” stock. These analysts have every incentive to provide full coverage to giants like DaVita and Fresenius due to their market caps of over $10 billion. But their coverage of ARA is just a perfunctory effort which is required to be part of the DaVita and Fresenius coverage universe. With ARA, the research goal is simply to refrain from pissing off a company that may later pay some banking fees. Anyone who has worked on Wall Street should recognize this phenomenon.

For anyone who doubts this, you can observe the following:

Since the IPO, the analysts repeatedly place their targets at a safe level which is consistently in accordance with the pricing model known as “slightly above the current price”. For even greater safety, all of these analysts then put price targets on the stock clustered in the same narrow price range vs. one another.

Despite the recent volatility in the industry and the complex accounting, all four analysts with recent updates placed targets within a very tight range of $22-23. That way no one needs to go out on a limb.

With ARA the analysts are just not paying attention to any of the details whatsoever. Not the imploding commercial mix. Not the surging put exercises by JV partners. Not the increasing litigation.

So now let’s look at a nearly identical situation where analysts covered a similar “high growth” health care stock which was backed and owned by one of the same banks’ large private equity clients.

** Adeptus – a preview for ARA shareholders **

If you want a clear preview of where ARA is headed, just look to the implosion of Adeptus Health (ADPTQ). The parallels between ARA and Adeptus are really just too direct and obvious to ignore. Just to make things simple, I will number the most obvious similarities.

Shares of Adeptus plunged from $120 in 2015 to near zero as the company began a rapid bankruptcy death spiral in 2016.

Adeptus was 1) a private equity backed 2) healthcare services IPO which 3) surged after it came public only to see 4) its results falter amid 5) overpayment issues which were 6) exposed in news reports over its 7) problematic business model. 8) Despite the emergence of obvious problems, the sell side banks were more than eager to hype the stock (and at Adeptus were then more than willing to accept the banking fees from the huge share sales by Adeptus’ private equity backer). 9) Numerous hedge funds naïvely piled into the stock. Just like ARA, Adeptus’ public problems began with a simple newscast revealing the problems with overcharging. Even until the bitter end, and despite the increasingly obvious problems, analysts were telling investors that Adeptus was a “buy buy buy”.

Adeptus soon filed for bankruptcy and the stock now trades for around $1.00.

Adeptus Health, the largest operator of freestanding emergency rooms in the US, ended the day down 58 per cent to another record low, after it said there was “substantial doubt” over its ability to continue as a going concern. Its rise and fall is a parable of Wall Street: a perfect illustration of how banks like to crank and crank that hype machine.

Note that Adeptus had a full slate of investment banks running the company’s private equity backed IPO, ensuring broad research coverage going forward. These same banks were quick to rake in millions in fees when the soaring share price allowed this same private equity backer to cash out of millions in stock at prices near the $120 peak.

As with ARA, the trouble started with a simple news story involving overcharging for procedures.

NBC news affiliate in Denver ran a documentary on what it claimed was a pattern of Adeptus patients being duped into paying huge sums for minor procedures

In retrospect, this news coverage signaled the “beginning of the end” for Adeptus. This can be clearly seen from the stock chart which began an inexorable decline. When Adeptus delayed its (weak) financial results by a day and then announced emergency measures, the stock quickly fell 70% in a single day.

Also like ARA, despite the onset of obvious problems, the FT showed how analysts refused to relent, overhyping Adeptus shares to investors, even as it plunged all the way down into bankruptcy.

Seven analysts covered Adeptus at the time. Every one of them had a “buy” recommendation….

…The CEO left soon after. Then came the lawsuits. This week Goldman said it had been named as a defendant in “several” putative class actions alleging misstatements and omissions in offering documents. Other banks have been named in suits too, including Morgan Stanley, BofA, RBC and Evercore, according to court filings….

Then came the disclosures on Thursday, as Adeptus said it could not file its annual report until it fixed “material weaknesses” in controls and reporting. It also flagged a long list of charges — including up to $67m for uncollectible receivables.

And then the very best part !!!!

The stock closed at $2.79, down 98 per cent from the top. Among the seven analysts still covering it, there were four “holds” and two “buys.”

If the parallels between Adeptus and ARA are not completely obvious to you then you should go back and read it again.

But again, don’t take my opinion for any of this. And while you’re at it, don’t listen to the sell side either.

The most compelling indication of ARA’s problems is that of the nephrologist JV partners who are now rushing to exercise their puts as fast as they can for the first time in ARA’s history.

Disclosure: I am/we are short ARA.

Additional disclosure: This article represents the opinion of the author. The author is short ARA. The author may choose to conduct additional transactions long or short in one or more of the stocks or related securities mentioned within this article within the next 72 hours.

Summary

In over 100 articles I have seldom used the word fraud to describe concerns. I reserve that word for the very worst situations where I have the highest confidence.

Within a few months after I expressed my fraud concerns on Osiris, we saw a CEO resignation, sweeping restatement of inaccurate financials and a criminal investigation.

Last Friday (after market close) Osiris announced that it would finally be delisted to the pink sheets.

I am short Osiris.

Lessons from Osiris can help people avoid catastrophic losses elsewhere.

Note: This article represents the opinion of the author. Nothing herein comprises a recommendation to buy or sell any security. The author is short OSIR.

Over the past few years, I have written at least 100 articles in various places online which have voiced my concerns over problems I have observed at publicly traded companies. Even when these problems are very significant, I almost never come out and explicitly use the word “fraud”. I reserve the use of that word for the true “worst of the worst” situations and where I also hold the very highest confidence. I generally only use the word “fraud” prominently once or twice a year.

Osiris Therapeutics (NASDAQ:OSIR) was clearly one of those situations. Here is the article I wrote on Osiris.

Following my article on Osiris, the company’s problems became evident quite quickly. Within 4 months, we saw a CEO resignation, a sweeping restatement of inaccurate financial statements and a criminal investigation. Obviously that was all quite bad. But it wasn’t until last Friday (March 10, 2017) that we finally got full closure. Last Friday, Osiris announced that it would be formally delisted from that Nasdaq and begin trading on the Pink Sheets as of this coming Tuesday. (As is often the case, when companies choose to release bad news, Osiris released this news well after market close on a Friday when most investors were already gone for the day.)

Yes, I am short Osiris.

Here are a few lessons we can learn from Osiris to help avoid catastrophic losses elsewhere in the market.

Lesson #1 – The cover up is often worse than the original problem. Don’t expect them to admit it.

As my regular readers know, I refuse to be rushed to publish anything I write. After I publish an article, companies will frequently put out aggressive public statements “refuting” my research and trying to discredit me. Rather than engage in back and forth banter, I typically remain mostly silent.

I act this way according to two very deliberate strategies.

Strategy #1: “The best way to expose a liar is to just let them keep talking”.

In addition, I also received some angry correspondence from the company which included denials of what I had said along with veiled threats of legal action against me.

Yawn. I was happy to say nothing and just let the waiting game begin.

That glowing and bullish press release was dated January 19th, 2016.

On February 4th, 2016, just two weeks after the glowing and bullish press release, Osiris CEO Lode Debrabandere abruptly resigned from the company citing unspecified “personal reasons”. Please note that he had been with Osiris for 10 years and then suddenly resigned just two weeks after issuing a press release to assure investors of Osiris’ bright future and recent “transformational” developments.

On March 14th, 2016 (just 55 days after our glowing press release), the audit committee then came to the conclusion that Osiris’ previously issued financial statements should no longer be relied upon. This is completely consistent with the concerns I had raised in my article.

On May 24th, 2016 (just 126 days after the glowing press release), Osiris finally announced that it was the subject of a criminal investigation by the US Attorney’s Office. The criminal investigation was regarding Osiris’ accounting practices, which again was exactly the focus of my article.

[Osiris is currently delinquent in filing its ongoing financial statements with the SEC. Since the time of the announcement of the criminal investigation, Osiris has not filed any 10Q or 10K filings and has not otherwise provided any update on the criminal investigation that I could find. So the current status of that criminal investigation remains unclear.]

So there you have it. In my view, 3-4 months seems like a pretty sensible amount of time to wait between the glowing press release from Osiris and the formal criminal investigation. It’s all about being patient.

In general, it has been my extremely consistent experience that “the louder they protest, the guiltier they are”.

Once their actions come under public scrutiny, many troubled companies will often try their best to divert attention away from themselves and onto their critics. For example, many companies will often say that shorting stocks or writing short articles is somehow illegal. They will invent conspiracies to distract investors citing things like “illegal naked short selling” or invent various “organized conspiracy plots” which are supposedly acting to drive down their share prices. They will often claim that they are initiating legal actions either through the courts or through the regulators such as the SEC.

Forcefield Energy’s response to my article

With Osiris, it took around 4 months for the Feds to launch their criminal investigation. To some people, that might seem pretty fast.

But with Forcefield Energy (NASDAQ:FNRG), it only took a few days for the Chairman to be arrested and the stock to be halted and then delisted. Now that was really fast.

As with Osiris, my article on Forcefield was one of the extremely rare instances where I felt comfortable using the explicit word “fraud” in my article.

My article was published on April 15th.

The company put out its aggressive response, denials and threats of legal action against me on April 17th (just two days later).

And on April 20th (just 5 days after my article), the Justice Departmentannounced that it had arrested Chairman Richard St. Julien as he was about to board a plane in an attempt to flee to Central America. On that same day, Forcefield stock was halted and then eventually delisted.

It was subsequently disclosed by the Justice Department that 9 individuals were indicted on sweeping fraud charges totaling $130 million.

Sadly, the depth and extent of the fraud at Forcefield are pretty much identical with what we see at other stock promotions and frauds.

According to the DOJ:

They took a company with essentially no business operations and little revenue and deceived the market and their clients into believing it was worth hundreds of millions of dollars through a dizzying round of unauthorized trades and deceptive promotions. In the end, the deceived investors were left holding the empty bag,”

Again, the implosion happened in just 5 days and Forcefield went from $7.50 to zero.

I knew that Forcefield was going to be a homerun short trade as soon as I saw the public statements being issued by the Chairman. Again, “the louder they protest, the guiltier they are”.

The “rebuttals” to my article from Forcefield are worth looking at in more detail. The press release reads like a boiler plate script which has been repeated over and over again by numerous fraudulent companies as they seek to divert attention from their own impending calamities.

While the specific wording varies from case to case, the elements are always the same in these public denials.

First, highlight that the author is short. Imply that this is somehow bad or even illegal. (It is not). State clearly that the company is acting to protect its shareholders from short sellers. Standard stuff.

Second, flatly deny, deny and deny all content of any negative and say that it is inaccurate. Don’t worry about refuting specific evidence in the article. Occasionally provide a few clever obfuscations which, in reality, don’t directly address the actual original concerns raised.

Third, make high profile and scary sounding threats of legal action through the courts or the SEC. Clearly if the company were guilty, they wouldn’t deliberately seek to involve the courts or the regulators, right ? (Wrong. By this point, these companies have nothing to lose. I have observed that in most cases any threats of supposed SEC complaints or lawsuits by these fraudulent companies turn out to be either sham efforts or outright lies.)

The quote from the DOJ above shows just how empty and utterly fraudulent Forcefield really was. Yet here are a few very sincere sounding quotes from Forcefield which came just 3 days before the Chairman was arrested. You will often see nearly verbatim quotes from other fraudulent companies once they come under public scrutiny.

From Forcefield’s press release:

[Here is the standard part about blaming shorts and claiming information is wrong]

The opinion was written by an individual investor, not a registered financial advisor, who has disclosed owning a short position in the Company’s common stock… The Company maintains that the article contains material inaccuracies about its management, business and prospects.

[Here is the standard part about “protecting investors” and pursuing legal remedies]

Richard St. Julien, Forcefield’s Chairman stated, “We are not going to stand by and allow our Company, officers and directors, employees and shareholders to continue to suffer through what appears to be an orchestrated short selling attack based on misinformation. We intend to defend ourselves and pursue all possible remedies against the allegations asserted in the opinion. Further, we will provide our shareholders and investment community a business update in a release pre- market on Monday April 20, 2015.

[Here is the standard part blaming some supposed conspiracy or short sellers and the part about “initiating legal action”.]

In addition, Forcefield stated that it had “requested that a regulatory agency review the trading activity in its common stock in addition to any relationships, arrangements and commonalities between short sellers and others.

Again, within 72 hours of making those strong and reassuring statements to the public, Chairman Richard St. Julien was sitting in the custody of the FBI and DOJ.

A response from Galena Biopharm

In February of 2014, Adam Feuerstein of TheStreet.com published a scathing article on Galena Biopharma (NASDAQ:GALE) describing undisclosed paid stock touting scheme which Galena insiders used to dump their shares at inflated prices. The authors behind these paid articles were assuming false identifies, often pretending to be doctors, biotech experts or hedge fund managers. Their supposed “expertise” always predicted in various articles that Galena would soar to new heights. This in turn did cause the stock to rise.

After Feuerstein’s article, the share price plunged and Galena was quick to issue a letter to shareholders which it said was being done (of course) “as a service to our shareholders”.

In Feuerstein’s article, he had cited online evidence of paid promotion behind Galena. But once highlighted, much of this evidence began to disappear from online locations.

Once the evidence disappeared, Galena then felt confident to describe Feuerstein’s writing as “tabloid like”, “accusatory” and “negative”.

The only facts in Mr. Feuerstein’s most recent article that are remotely accurate are that Galena previously engaged the DreamTeamGroup and that insiders at the company, including me, divested shares in mid January. All other accusations in this article – as with his prior reporting on Galena – are specious and conveniently arranged to create controversy.

As soon as I saw this public statement from Galena, I literally laughed out loud. I cackled. I guffawed. I chortled.

Once again, “the best way to expose a liar is to just let them keep talking”.

Unbeknownst to Galena or Feuerstein, at this very time, I was already elbow deep into my own investigation into the paid promotion behind Galena.

Shortly thereafter, I released the smoking gun documents obtained directly from the guilty promoters which described in detail the intimate involvement of Galena management in actually coordinating and even editing the undisclosed paid articles which were being published during an ongoing paid campaign using the Dream Team Group.

[In December of 2016, Galena announced that it had reached “an agreement in principle” to settle with the SEC. However, just a few weeks later in January of 2017, Galena then announced that it was now under criminal investigation by the US Attorney’s Office and the Department of Justice for separate issues related to the marketing and promotion of fentanyl.]

Prior to the scandal (and as a result of the paid promotion), Galena had traded as high as $8.00. Galena now trades for around 58 cents.

The aggregate lesson from these examples above should be simple. Once there are indications that a company has misled investors in the past, it should come as no surprise that they are willing to mislead investors in ongoing press releases. History has shown that fraudulent companies are more than willing to put forth massive and outlandish statements that are absolutely and utterly false. Oftentimes, they will literally say anything regardless of how ludicrous or unsubstantiated it might be.

Lesson #2 – Markets are rational in the long term but irrational in the short term

As much as I like to take credit for exposing Osiris, the fact is that I was not the first one to publish concerns about the company.

Prior to my article on Osiris, author Edward Vranic, CFA had published no less than 3 very concerning articles highlighting his own concerns about Osiris. I felt that his concerns were extremely valid and were very well articulated.

Despite the concerns raised by Vranic, the stock barely budged, sticking closely to a price of around $10. The market simply didn’t care. For the market to ignore such significant information was truly irrational.

Once I observed that the market didn’t care about Vranic’s concerns, I naturally assumed that it would also not care about any subsequent concerns that I might have just a few weeks later. But for the good of the market, I chose to publish my research anyway.

I was quite surprised to see the stock quickly drop by as much as 40% following my article. The concerns that I raised were entirely different than those raised by Vranic, but I felt that they were largely of the same magnitude.

The fact that the market reacted so strongly to one set of concerns while virtually ignoring the other again shows how irrational and unpredictable that markets for these small cap controversial stocks can be.

And then the mystery deepens even further.

Following the announcement of the financial restatement in March, Osiris plunged to a new low of $3.55. That seems pretty rational so far, although I would have possibly expected a bit of a deeper decline.

But then for some reason the stock steadily rebounded to prices well above $6.00. This was true even after the criminal investigation was announced.

Ultimately we can see that Osiris is now being delisted to the pink sheets. The stock will now grind down to well below $1.00 where it belongs.

The lesson to be learned here is this:

In the short term stock prices can remain irrationally elevated even in the face of bad news.

In the long term stock prices will eventually converge to their fair value.

The problem is that the demarcation point between “short term” and “long term” often happens in just an instant, leaving those who own the stock subject to immediate and unavoidable losses.

The lesson here is that holding on to shares of problematic and controversial small caps is demonstrably a very bad idea. Even if they seemed immune to their problems yesterday, they will often plunge suddenly and without any advance notice, leaving investors no opportunity to get out.

Lesson #3 – Sell side research is generally worthless

At the time of my article on Osiris, numerous concerns were already starting to leak out into the public domain. Ed Vranic had already been quite vocal and the concerns I had raised were all based on publicly available information. Clearly the stock was headed dramatically lower from its then level of around $10.00.

But for some reason Piper Jaffray continued to support the stock with a whopping $28 price target. Even without the baggage of obvious malfeasance, Osiris’ underlying business simply couldn’t justify such a lofty price target.

Piper continued to maintain bullish targets even after my article, and as the stock hit $5.00. Piper continued to maintain its bullish targets even after the CEO resigned. And somehow Piper continued to stay bullish even after the audit committee recanted the company’s historical financials as being inaccurate.

Only in June of 2016 (just days after the announcement of the criminal investigation) did Piper finally “suspend” its rating of Osiris. At the time, it had still maintained a $12 target on Osiris.

It continues to puzzle me how sell side analysts continue to have any impact on share prices at all. I really don’t know why anyone continues to listen to them. It is widely known that as much as 95% of sell side targets are with Strong Buy, Buy or Hold recommendations. The occasional Sell rating is hard to find and inevitably comes well after the share price has already plunged, making such a “recommendation” completely useless to investors. There is simply no incentive for sell side analysts to ever put a Sell rating on a stock. As a result, they just don’t do it, regardless of how horrific the stock has become.

And yet for some reason we can still see share prices often pop when some sell side analyst initiates coverage or raises his target.

Despite my general disdain for sell side analysts, there is one guy who deserves a special positive shout out.

Very early in the game, when the stock was around $15, Brean Capital analyst Jason Wittes downgraded Osiris to a Sell with a target of $8.00. He also cautioned investors that emerging concerns could send the stock to below $5.00.

Wittes deserves strong kudos for being right, for being early and for accurately predicting quite closely the near term impact on the share price. He also deserves extra kudos for demonstrating very rare courage in moving against the herd by actually putting out a Sell rating at all.

Sadly, coverage and analysis like that from Witte is the vast exception to the rule.

Conclusion

When looking at fraudulent companies, share price implosions often occur in stages.

With Osiris, the first phase only took a few weeks after my article to begin, starting with the resignation of the CEO. This intensified once we saw restatements of inaccurate financials and a criminal investigation a few months later.

All of this fallout occurred not long after Osiris put out a press release designed to reassure investors and “refute” critics like me. I hope that investors will learn the lesson that such press releases and the statements they contain should be viewed with a very large grain of salt. The lesson I have consistently observed is that “the louder they protest, the guiltier they are“.

In many cases, companies which demonstrate clear underlying problems will be headed for ultimate delisting and implosion. But in many cases their stocks will take a pause on the way down, typically after initial plunges of around 50%. The final plunge to the pennies will then come with little notice when the company is ultimately delisted.

Sell side research is generally not worth the paper it is printed on. In most cases, I ignore it completely. Although there are a few exceptions.

In the article above I only cited a few examples to support these lessons. Each of these were based on articles written by me.

But aside from Osiris, Forcefield and Galena, I have had similar experiences following many others of my past articles. After my articles are published, we have frequently seen some form of aggressive response and then some moderate level of share price decline. Yet ultimately we have consistently seen these stocks eventually plunge by 80-95% from their promotional highs and also become the subject of either SEC investigations, class action lawsuits or forced resignations of senior management.

Nearly $100 million in revenues, from 4 countries on 3 continents. Cemtrex pays auditor just $20,000 per year in audit fees to sign off on financials. Non-sense.

Note: This article represents the opinion of the author. Nothing herein comprises a recommendation to buy or sell any security. Following exposure of the problems listed below, I expect that many of the links cited may be changed or removed by the parties implicated. I have made various efforts to retain pdf copes and screen shots where possible. The author is short shares of CETX.

Note: The short interest in Cemtrex (NASDAQ:CETX) is extremely low at just 400,000 shares (just a single day’s trading volume) such that this has created a very interesting situation.

Recent trading

Yesterday we saw shares of Cemtrex fall by 13% on nearly 1 million shares of volume with no apparent news. But in fact, on the previous trading day (Monday was a holiday), Cemtrex’s investment bank, Source Capital, had its SEC and FINRA registrations terminated nationally and in all states.

There was no announcement and no press release that I could find. The only way to find out was by checking FINRA’s Broker Check website. FINRA has still not uploaded the details of the latest violations, but we can see from a Florida lawsuit that Source was forced to pay a massive settlement to retirees who were sold risky and unsuitable investments that quickly went bankrupt.

As my regular readers know, I often express significant concerns about problems I find with publicly traded companies. But these readers know that I will seldom come out and actually use the word “fraud”.

But I feel comfortable that the extensive use of the word “fraud” is entirely appropriate in this article for the reasons below. The points I will make below are supported by on the ground photographs as well as official government documents from various agencies.

1. Cemtrex is being heavily promoted by a promotion firm known as “Small Cap Specialists” (AKA “SCS”). Past SCS promotions have been repeatedly halted or delisted due to financial irregularities or outright fraud. (Examples include delisted frauds Forcefield Energy and Code Rebel, among others). On its website, the SEC has gone so far as to specifically warn investors about these exact type of promoters as an indication of micro cap fraud.

2. Documents indicate that Aron Govil is paying this same promoter SCS to promote Cemtrex via wire transfers from an undisclosed entity in New York. The paid promotion by Cemtrex insiders has not been disclosed to Cemtrex investors. In the past, I have seen numerous examples of other companies engaged in similar undisclosed paid promotions that resulted in Federal charges or lawsuits for securities fraud.

3. As the share price has soared due to promotion, documents show that shares held by Cemtrex insiders (Aaron Govil, Saagar Govil and CFO Dela Rama) have been decreasing substantially during 2016, yet Cemtrex insiders havefailed to disclose any sales on Form4’s during 2016. On places like Twitter, the Govils continue to tout the stock, encouraging retail investors to buy.

4. The controlling partner behind Cemtrex’s auditor was banned by the SEC and PCAOB for conducting fraudulent audits or reviews of public companies while performing little or no work and without even being licensed. Cemtrex’s auditor continues to claim that the firm is run from an office in Texas. But photos show that this address traces to a long-since vacant strip mall. The audit firm is not even licensed to practice in Texas. The only listed phone number in the US has been disconnected. That partner has repeatedly audited public companies under the guise of differently named audit firms which have then been shut down. When one audit firm gets shut down, he has repeatedly created new ones and then audits the same clients, using the same personnel, reporting the exact same address in Texas. Cemtrex’s prior auditor was shut down by the PCAOB and is now classified as a “prohibited service provider“. Despite having revenues of nearly $100 million and operations in 4 countries across 3 continents, Cemtrex has only paid these auditors a mere $15,000-$20,000 per year to “audit” its complex financials.

5. The investment banks and IR firms hired by Cemtrex (including Source Capital) have repeatedly represented other heavily promoted companies that have been promoted by SCS or other promoters. There has been long running and significant involvement with companies, individuals or activities implicated in securities fraud.

Background

Over the past few years, I have exposed dozens of stock promotions, pump and dumps and outright frauds. The result tends to be the same in each case. After these stocks are exposed, their share prices fall by at least 80% to just pennies. In some cases, after I have exposed these companies, we have seen SEC investigations, criminal indictments, management and auditor resignations and other fallouts. In some cases, this has happened within just days of my article being published. In other cases, the stocks have simply imploded without further fanfare.

With Cemtrex, there is a reason why the numbers appear to be “too good to be true”. There is a reason why there has been a surge of glowing media articles touting Cemtrex and its management. And there is a reason why the stock keeps selling off even when supposedly good news is released.

There are clear reasons why hundreds of small retail investors have been duped into buying the stock and these are all thoroughly debunked and exposed below.

Industrial Products and Services (“IP”) offers services for in plant equipment erection, relocation, and maintenance; air filtration and environmental control products; and monitoring instruments, for measurement of emissions of Greenhouse gases, hazardous gases, etc.

Cemtrex was founded 15 years ago by Aron Govil. Govil also runs Ducon Technologies which operates out of the same address as Cemtrex and which owns Cemtrex shares. Through his personal and Ducon holdings, Aron Govil is the largest shareholder in Cemtrex.

In 2008, Govil appointed his 23 year old son, Saagar Govil, into various executive and board positions at Cemtrex. Young Saagar had just graduated from undergrad that same year in 2008, with no prior reported work experience.

Just 2 years later, at the age of 25, Saagar was appointed CEO of Cemtrex and father Aron took the role of executive director and board member.

Following the appointment of Saagar Govil as CEO, Cemtrex quickly embarked upon a slew of acquisitions, primarily of obscure companies in foreign countries well outside of the US.

Cemtrex has employed an aggressive IR and media relations firm to obtain an avalanche of positive media coverage around the Govils and Cemtrex.

Saagar has recently been the subject of a flood of glowing media attention due to his young age and the apparent rapid growth of Cemtrex’s revenues.

Between 2012 and 2016, reported revenues grew from $12 million to $94 million, largely driven by acquisitions of insolvent companies in overseas markets, which then contributed heavily to Cemtrex’s results as soon as they were acquired.

Key points underlying fraud thesis

Again, based on my past experiences and observations, I believe that there is a very strong chance that Cemtrex gets delisted outright and will go to zero.

The key points I will address are as follows:

Point #1 – The massive paid by promotion, secretly paid by Cemtrex management

This is precisely what we see with Cemtrex and the promotions being run by a firm known as Small Cap Specialists (AKA “SCS”). SCS has been behind dozens of imploded stock promotions including a number of high profile frauds which were halted and / or delisted by the SEC.

SCS happens to be the exact same promotionfirm that Aron Govil is paying under an undisclosed entity name to run a pump campaign on Cemtrex. SCS has now been promoting Cemtrex for over 1 year. During that time, the share price quadrupled.

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First I will show how SCS repeatedly runs paid promotions on fraudulent companies which are then halted and/or delisted.

Second I will show the documents which show that Aron Govil is paying SCS to promote Cemtrex, using an undisclosed entity name.

And in the next section I will then show how Cemtrex insiders are secretly selling shares during the paid promotion campaign, without disclosing the sales to investors.

Evidence of various paid promotions on Cemtrex along with the payments involved can be found at promotion tracking sites such as Hotstocked.comand Stock promoters.com. But these sites typically only capture a fraction of the promotions under way.

As we can see from these sites, a well oiled stock promotion machine began aggressively pumping Cemtrex through a wide variety of online channels. So far, over $1 million has been paid to stock promoters.

I include a partial screen shot showing various paid promotions on Cemtrex at the bottom of this section, or just click the links above. Here are just a few of the examples. There are dozens and dozens more, each of which tend to cost from $10,000 to $50,000 a pop.

I will demonstrate below that Aron Govil is behind Southern Steel & Construction which is paying SCS. SCS has been responsible for numerous paid promotions on Cemtrex.

This aggressive paid promotion is what took the stock from below $1.70 to over $7.00 in 2016.

(For more details on the past frauds or promotions by SCS which were halted, delisted or imploded, see Appendix A)

Aron Govil’s hidden paid promotion using SCS promoters

Here is just one example of an SCS promotion of Cemtrex which was paid for by an entity called “Southern Steel and Construction”. This promotion was dated October 2016, but it notes that SCS had been covering Cemtrex for a full year prior.

We can see below that just two or three days coverage cost “Southern Steel” $30,000, which was paid via bank wire.

(Note: This single payment to SCS for just 2-3 days of stock promotion is more than all the audit fees paid to its auditor Bharat Parikh for the full year for any of the last 3 years !)

The SCS promotion begins with:

Good morning everyone, This week’s featured profile is one of our favorite small cap’s since our initial coverage in October 2015. Cemtrex, Inc. (NASDAQ: CETX) CETX has been an amazing growth story through organic and acquisitions since our initial coverage last year. We are excited about what may be in store for this company going forward.

Here is a screenshot noting payment of $30,000 by Southern Steel for just 2-3 days coverage:

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So just who is Southern Steel ?

The only individual identified on a search from theNew York Department of Stateis Aron Govil at 19 Engineers Lane (which is Cemtrex’s address).

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First off….so New York’s corporate records for Southern Steel, which is paying for Cemtrex promotions by SCS, lists only Aron Govil at the same address as Cemtrex.

And then second….Southern Steel’s entity status is listed as “inactive,” meaning that since August 2016 it has engaged in little or no other business activity other than paying SCS to promote Cemtrex.

In fact, this information is a bit difficult to find. By default, the NY State database only shows “active” corporations. So when searching for this, one must opt to explicitly search for “all” corporations, both Active and Inactive.

When a corporate insider makes sales of their own stock, this is very material information to outside shareholders because presumably insiders know much more than the rest of us.

When an insider (management figure, director, or 10% holder) makes an initial purchase, that insider is REQUIRED to report the transaction on SEC Form 3.

Subsequent transactions by such insiders (either buys or sells) are then REQUIRED to be reported on SEC Form 4.

The Form 4’s are very important because they REQUIRE the insider to disclose:

· the date of transaction

· the number of shares transacted

· the share price received

Retail investors in Cemtrex have tried to remain confident under the assumption that management is holding strong and not dumping shares.

Precisely during the time of the paid promotion campaign, and along with the soaring share price, the number of shares held by Aron Govil, Saagar Govil and CFO Renato Dela Rama have all decreased significantly. The total decrease in their shares amounts to nearly 1 million shares, amounting to as much as $7 million in proceeds in 2016. You can do the math yourself: During 2016, Cemtrex’s share price ranged from $1.65 to $7.38.

Yet no form 4’s have been filed to disclose any share sales from any Cemtrex insiders whatsoever. Here is a link to all ofCemtrex’s SEC filings.

It truly defies all common sense that ALL members of managementhad their shareholdings decline substantially while precisely NONE of them has filed a single Form 4 to disclose it.

For those who wish to double check for themselves, here are the reference SEC filings.

The table below shows the number of shares held as of each of those dates. We can see that for each of Ducon, Aron Govil, Saagar Govil and Renato Dela Rama, the number of shares has declined substantially.For the directors, we do not know, because they never filed the required Form 3’s to disclose their ownership.

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Ducon Technologies

In November of 2015 (exactly when the paid promotion from SCS began), Ducon Technologies disclosed a purchase of 65,732 shares at a price of $2.55 for a total amount of $167,617. As disclosed, this took Ducon’s holding of Cemtrex common stock to a total of 433,219 shares. Ducon Technologies is controlled by Aron Govil, who is behind the entity paying for the undisclosed stock promotion.

But according to the most recent Proxy filed in January of 2017, Aron Govil’s Ducon Technology now only has 102,951 shares. It therefore got rid of 330,268 shares during 2016. Because there were no Form 4’s filed, we don’t know the dates or the amounts of any sales. But we can see that the share price ranged from below $2 to above $7 in 2016. Therefore, depending on when its shares were sold, Ducon Technology could have sold up to $2.3 million.

Aron Govil

By comparing the Proxy’s issued in 2016 and then 2017, we can also see that shares held under Aron Govil’s own name declined by 222,049 shares in 2016. Again, depending on when these were sold, they could have been worth up to $1.8 million.

Saagar Govil

As we will see, Saagar Govil’s share holdings increased by 100,000 during 2016. But during the year he also awarded himself 400,000 new shares via option grants, such that his position should have increased by 400,000. So clearly his net position actually declined by 300,000 shares.

For Saagar Govil, the 300,000 decline amounts to up to $2.1 million in 2016 assuming the sale of stock at share prices up to $7.00.

In September 2016 (with the stock having just hit new highs for the year), Saagar Govil also purchased an upscale condo in New York valued at precisely $2.25 million.

(The timing, the prices and the disclosure omissions around Saagar’s 400,000 option grants also leads me to the question of if these were backdated to occur at artificially low prices. I will show the detailed documentation of in a section below).

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CFO Renato Dela Rama

Moving on, we can also see that the number of shares held by the CFO also declined by 19,833, again with no Form 4’s being filed. Depending on when the sale was made, this would have a value of up to $138,831 (or more than triple his reported salary).

The Directors

With directors Sunny Patel and Shamik Shah, we can see that both directors report owning a few thousand shares worth up to $30,000-$40,000. But no initial Form 3’s were ever filed to disclose when they received these shares or at what price. We also don’t know how many shares they initially received in total, such that there may have been substantial selling here as well. Typically, new directors are awarded shares as of the date they join the board. For both of these directors, that would have been the Spring of 2015. New shareholdings by directors are ALWAYS required to be filed to the SEC, but NONE were ever filed by these directors.

The use of Twitter, StockTwits and online message boards to promote Cemtrex

In my past articles I have exposed clearly how paid stock promoters will also infiltrate online message boards, social media (Twitter) and online financial blogs. They then pose as independent individuals who rally the enthusiasm behind their promoted stocks. Once you know what to look for, these paid promoters often become obvious online. They suddenly appear out of nowhere and begin aggressively cheering on a certain stock. At some point (when the promotion is ending) they disappear just as quickly and this is when we see the stock start falling apart.

In addition, all throughout the paid promotion campaign, both Aron Govil and Saagar Govil have been actively cheerleading Cemtrex’s stock price on places like Twitter, encouraging retail investors to BUY BUY BUY. Obviously, this is highly unusual for any executive of any publicly traded company. They are supposed to be running a company, not sitting in front of their computers, Tweeting to promote the stock price. It also raises the potential for Reg FD violations. This is why we almost never see CEOs publicly touting their own stock on Twitter.

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Point #3 – Cemtrex’s defunct auditor gone missing, history of fraud

Up through 2014, Cemtrex was using a defunct auditor called Li & Co. But Li & Co. was shut down by the PCAOB. During the investigation, Li & Co. simply refused to provide subpoenaed information to the investigators. That defunct audit firm is now listed as a “Prohibited Service Provider” and is no longer allowed to provide audit services.

Following that, Cemtrex began using Bharat Parikh & Assoc as an auditor. Bharat Parikh is a small audit firm based in India, not the US, but with a supposed office in the US for auditing US clients. Even in recent weeks on Cemtrex’s just issued 10K filing, it continues to list Bharat Parikh’s office address in the US as 4940 McDermott Rd., Plano, TX.

Here is a screenshot of Bharat Parikh’s signature from Cemtrex’s form 10K filed with the SEC just a few weeks ago, dated December 28, 2016.

In fact, this corresponds to a vacant strip mall office in Dallas. Here are some photos of that vacant office space at 4940 McDermott Road. The photos were taken just a few days after that SEC filing came out.

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Clearly even though these offices appear to have been vacant for quite some time, Bharat Parikh continues to claim to the SEC that he is running a team that is performing audits out of this office.

In addition, the US phone number listed on the auditor’s website has been disconnected.

We now encounter a host of problems:

First, (obviously) the fact that Cemtrex’s auditor claims to be running a busy audit firm out of a long-since vacant building in a strip mall is troubling. Likewise, the disconnected phone number is equally troubling.

Second,Texas State Board of Public Accountancyhas no record of Bharat Parikh even having a license to provide audits for public companies. Click the link above to search the database. Enter in any combination of Bharat+Parikh and / or BPA, etc. There is nothing.

Third, Bharat Parikh & Associates is actually controlled not by Mr. Parikh, but by Mahesh Thakkar who holds a 51% stake in the auditor. Thakkar wasbanned by the SEC and the PCAOBdue to accepting fees to provide fraudulentaudits, and also for operating without a license to even provide audits at all. At the time, he was running an audit firm under a different name (Thakkar CPA / The Hall Group). But it was actually operated out of the same address (4940 McDermott), with the same group of personnel auditing the same clients. It is no coincidence that past clients from that partner then ended up simply switching over to the “new” firm using the “new” name Bharat Parikh (i.e. Cemtrex’s auditor) out of the same exact address. Thakkar has operated audit firms using multiple names, changing the name of the firm each time he gets shut down. Various names used by Thakkar include: The Hall Group, Thakkar CPA, and Bharat Parikh and several others. Most recently he has attempted to use the name TMK LA (in which Mr. Bharat Parikh is listed as his partner).

Fourth, as we will see, Cemtrex pays this absentee auditor a mere $15,000-$20,000 in audit fees per year, despite claiming revenues of nearly $100 million from operations which span 4 countries and 3 continents. As highlighted by CFO.com, smaller firms tend to pay roughly $5,000 in audit fees per million dollars of revenue. That should place Cemtrex at nearly $500,000 in expected audit fees (even without sprawling international operations).

Here is how we know all of this.

If you look closely at the picture of 4940 McDermott, you can make out the glue outline of the words “Perfect Tax and Finance“. Perfect Tax was founded and operated by Mahesh Thakkar, CPA and lists 4940 McDermott as its address. Thakkar partnered with Bharat Parikh out of this same address, which is again the same address that continues to be listed for Bharat Parikh in Cemtrex’s SEC financials even now.

Here we can see that Bharat Parikh and Thakkar listed as General Partners in an LP called “TMK LP” that claims to provide CPA services, again from 4940 McDermott Road.

We can also see below from the Texas Secretary of State that Thakkar was listed as the CONTROLLING PARTNER in Bharat Parikh Associates, with a 51% stake and he uses the same address as Bharat Parikh, both in India and the US. Once again, this is 4940 McDermott Rd.

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HERE we can see where Bharat Parikh controlling partner /predecessor Thakkar was thenbarred by the SECfrom practicing accounting for public companies.

We can see then that prior to taking control of Bharat Parikh, Thakkar had previously run his audit shop under a different name in Texas, again covering public companies. This firm was Thakkar CPA d/b/a “The Hall Group CPA’s”.

As with all of the other firms listed here, of course Thakkar CPA’s operated out of 4940 McDermott, the same vacant strip mall. (In the link above, simply type in the firm name of “Thakkar”).

Here we can see that Thakkar has now been officially suspendedfrom practicing accounting due to various violations including “violating auditing standards“, “violation of rules of professional conduct” and “lack of fitness to serve the public as a professional accountant”

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In its previous incarnation, Thakkar had formed Thakkar CPA’s to perform public company audits. But he had two problems. First, he had no PCAOB license to perform audits and second he had no clients.

As a result, he simply bought an existing audit firm called “The Hall Group CPA’s” which had a number of existing public company clients. Thakkar then began signing off on audits for these clients. But according to the SEC, he never became registered with the PCAOB, which is required for auditing public companies.

And here we can see where audit clients such as Pink Sheets tradedInolifesimply switched over from the audit firm calling itself “Thakkar/Hall Group” to the one calling itself “Bharat Parikh” to complete their audits by a supposedly “new firm”operating out of the exact same address by the same group of people.

According to the SEC complaint, there were actually a host of deep and concerning violations by Thakkar/Hall. You can click below to read them all, but we will focus on just a few of them below.

These proceedings arise out of Thakkar CPA, PLLC d/b/a The Hall Group CPAs (“Thakkar CPA” or “successor firm”) issuance of 15 public company audit reports while it was not registered with the Public Company Accounting Oversight Board (“PCAOB”). Thakkar CPA’s audit reports misrepresented that the firm was properly licensed and registered with the PCAOB and falsely stated that it conducted audits in accordance with PCAOB standards.

The Hall Group, Hall, Helterbran, and Cisneros collectively failed to conduct at least 16 annual audits and 35 quarterly reviews in accordance with PCAOB standards in at least three ways: (1) they repeatedly failed to prepare adequate audit documentation in connection with audit and review engagements; (2) failed to conduct – or failed to obtain – an engagement quality review (“EQR”) of audit and review engagements by a qualified reviewer; and (3) on at least four engagements, The Hall Group and Hall performed audit services while the firm’s independence was impaired. As a result, The Hall Group falsely stated that it conducted its audits in accordance with PCAOB standards in at least 16 annual audit reports for eight issuers. Additionally, Hall, after becoming CFO of DynaResource, Inc., allowed Thakkar CPA to provide audit services to DynaResource, Inc. even though he knew he had a direct financial interest in and a business relationship with the company’s external audit firm.

So Bharat Parikh’s controlling partner / predecessor was banned because on 35 separate occasions it did not prepare audit documentation, it did not have a partner even conducting audits and it falsely attested that it had properly conducted audits.

Basically, Thakkar was getting paid small amounts of money to sign off on these audits without really doing any work at all !

In addition, the firm signed off on audits in a company with which it clearly had a direct financial interest and was therefore not independent.

Here is why this matters. (And this should become quite obvious).

Cemtrex purports to generate revenues of nearly $100 million coming from 4 international subsidiaries spanning 3 continents. Presumably this makes Cemtrex relatively complicated (and expensive) to audit. This audit then gets even more expensive when the company needs to integrate ongoing acquisitions of totally new businesses. Any realistic cost assessment of such audit work for any normal company could run as high as $500,000-$1 million. Easily.

Yet in Cemtrex’s 10K we can see that paid it’s absentee Indian auditor a mere $20,000 to perform its audit work in each of the last two years! And in the previous year, audit fees amounted to just $15,000.

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Even for a small company with operations in just a single city, no auditor can justify even preliminary work for just $15,000-$20,000. For a company operating in 4 countries across 3 continents, this is just patently absurd. And it seems very consistent with the history of Thakkar / Hall etc. signing off on so-called “audits” without actually doing any real work.

In my view, the $15,000-$20,000 looks like little more than a convenience payment for a rubber stamp signature.

The situation on the inside of Cemtrex is no better. Cemtrex’s CFO is Renato Dela Rama. Presumably in this role, he would be responsible for coordinating the audit with Bharat Parikh, if one were actually being done.

But in 2015, Cemtrex reported in SEC filings (see below) that Dela Rama received zero compensation for this role in 2014 as well as in 2015. In fact, on his LinkedIn page Dela Rama does not even disclose that he even works for Cemtrex at all. Instead, he only lists that he is the controller for Ducon Technologies, which is run by Aron Govil.

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So, lets get this straight: Cemtrex’s CFO doesn’t even report that he is the CFO of Cemtrex and for the past several years, Cemtrex also discloses that he wasn’t even getting paid for that role.

In fact, he is actually getting paid by Aron Govil via Ducon. And Aron Govil is the guy who is using an undisclosed entity to pay notorious stock promoters to finance a touting campaign on Cemtrex.

Got it ?

In 2017, Cemtrex’s SEC disclosure suddenly contradicts its 2015 disclosure. The fact that a change was made is never noted and certainly not explained. Years after the fact, Cemtrex began claiming that it had actually paid Dela Rama $40,000 per year in each of those previous years.

In fact, the $40,000 number becomes even more troubling.

Even at $40,000 this is exceptionally low pay for a CFO of a supposed multinational conglomerate. It is also well below what he gets paid by Aron Govil at Ducon, where Dela Rama is not even CFO. No one would be expected to devote full time attention to a multinational company for just $40,000 per year, especially not in New York. My secretary in New York used to make over $60,000.

For reference, here we can see that average salaries for any full time CFO in the US was $315,947 as of December 2014 (about 8x what Dela Rama is supposedly being paid, if he is being paid at all).

And to be clear, over $1 million has been paid to notorious stock promoting firms to pump up the share price while only $15,000-$20,000 has been paid to supposedly “audit” the financials for the entire company. Meanwhile the CFO is only supposedly paid $40,000.

For the reasons above, I have precisely zero confidence in the financials being reported by Cemtrex. This will become especially clear below when we look at the spectacular performance which Cemtrex has reported immediately after acquiring obscure foreign companies which are revealed to be entirely insolvent just before being acquired by Cemtrex.

The Cemtrex financials signed off on by Bharat Parikh and CFO Dela Rama have now shown 20 straight quarters of apparent profitability and soaring revenues. This “success” has then been widely echoed and amplified by the aggressive stock promoters being paid by Aron Govil through an undisclosed entity. And this is exactly the formula which caused the stock to soar from below $2.00 to over $7.00 in 2016.

Point #4 – The 3rd party service providers

Whenever I come across another paid stock promotion, I always, always, ALWAYS know exactly what I will find next. Each of these companies relies on the same 3rd party service providers such as law firms, investment banks and “IR firms“. The world of small cap stock promotion is basically a small country club and all of these guys know each other.

With Cemtrex, we can see that the company has relied heavily upon Chardan Capital and Source Capital as its bankers. For IR, Cemtrex uses Irth Communications. Each of these firms will be detailed below. But it is safe to say that there is very notable overlap between the client lists of all three firms. They all work for many of the same firms and people. From there, we also see that they also service the exact same companies which have been heavily promoted by the exact same stock promoters, including SCS, listed above. In each case, these client companies have then repeatedly imploded or been halted or delisted, due to fraud.

This raises two issues:

First, if the last 20 or so companies represented by these third parties generally skyrocketed due to excessive promotions and then imploded, it seems like a safe assumption for any objective investor to suspect that Cemtrex might do the same thing. This is just common sense.

Second, when this pattern of shareholder destruction is so obvious with their client lists, why on Earth would any company ever select these 3rd parties to represent them (unless they simply had no alternatives, because they too were nothing more than a blatant stock promotion). Again, this is just common sense.

In February, just days after the completion of Cemtrex’s rights offering, we saw the following headline:

Goodman & Nekvasil, P.A. won a FINRA arbitration award against Source Capital Group on Feb. 3 while working on behalf of three retirees, William B. Lashlee and Keith and Joyce A. McCrea. Lashlee is an 88-year-old retired native of St. Simons Island, Georgia, and the McCreas are a retired couple who live in Yorkville, Georgia.

Both groups alleged they were sold unregistered and unsuitable investments in IPG stock by Joseph Hooper, who was working as a representative. Lashlee invested $220,000 and the McCreas invested $590,000 for a combined total of $810,000 in IPG stock.

IPG quickly went bankrupt and Source was found to have been negligent.

As of last week (February 17th, 2017), we can see that Source Group had its FINRA registrationsterminatedin all states in which it was operating. FINRA notes that Source Group ceased business operations in February 2017.

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From Source’s website we can see that the firm has raised money for a number of other heavily promoted microcaps which then imploded. Like Chardan below, this includes a number of tiny Chinese reverse mergers which were delisted (but only after they raised substantial capital from US investors).

My regular readers will remember back when I previously exposed a massive stock promotion ring run by “The Dream Team Group“, which also operated under the name of Mission IR. Dream Team / Mission IR had recruited numerous authors to write extensive undisclosed paid promotions on dozens of micro cap stocks. These authors would pretend that they were industry experts or hedge fund managers and would write aggressive articles recommending the client stocks. These stocks then soared in price, allowing the companies and their management to sell stock at inflated prices. After my expose, each of the implicated companies ended up plummeting by as much as 95%, and a number of civil suits and SEC investigations ensued.

Dream Team / Mission IR were the architects behind a widespread ring of stock fraud and promotion. I even produced the internal documentation to prove it.

Note that a number of the companies which attend Source’s investor conference also happen to be banked by Chardan and/or are clients of Irth Communications as well. These attendees of Source’s disruptive growth conference also happen to be heavily promoted by the same promoters listed above, including our favorite, SCS. This is easy to see by logging on to either Hotstocked.com or Stockpromoters.com.

At FINRA’s Broker Check website, we can also see where Source was fined by FINRA for having sold investments to investors “without disclosing material facts” and sold investments by making “exaggerated promises in multiple emails” as well as selling securities “at prices which were not fair“.

Either way, following the termination of its FINRA registration in all states, it appears that Source Capital is no more.

Chardan Capital Markets

Cemtrex retained banker Chardan Capital Markets to run its S3 offering in 2016. Cemtrex was then forced to withdraw the offering because Cemtrex did not meet the requirements as a result of failing to file required SEC documents .

Chardan and its management have a long history of run-ins with the SEC and FINRA. This includes various reports of manipulating small cap stocks, insider trading activity, failure to disclose various stock holdings and transactions as well as defrauding the US Small Business association out of $35 million. Chardan then launched into the Chinese Reverse Merger / SPAC game. Geoinvesting subsequently highlighted no less than 17 different examples of Chardan Chinese reverse mergers/SPACs, the majority of which completely imploded following exposure of or allegations of fraud.

Irth Communications – Cemtrex’s “IR” firm

Cemtrex’s IR firm is Irth Communications. As with Source Group above, Irth is listed as an IR partner of Mission IR (AKA the Dream Team Group) which was found to be behind a massive illegal stock promotion ring.

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As shown on its website, Irth has been responsible for various aggressive media placement campaigns for its clients, getting the stocks and their management strong favorable mentions in mainstream media outlets.

But as we can see below, many of these stocks are the same stocks that have been heavily promoted by the promoters listed above, including our favorite, SCS. These stocks have then eventually imploded despite tremendous positive coverage generated by Irth.

Many retail investors have been lured into buying Cemtrex stock solely as the result of seeing these high profile, positive media placements on Cemtrex which have been entirely arranged on their behalf.

As for the glowing media coverage that has suddenly exploded upon Cemtrex and the Govils, this is something that I have seen on many occasions.

For example, in January of 2011, China Media Express (formerly CCME) obtained the following headline from none less than Forbes:

Just 60 days later, CCME was delisted when it was uncovered as an abject fraud. Thanks Forbes.

In the US, the micro cap Organovo shot up 3.5x from $4.00 to $14.00 following the publication of this article in Popular Science, which was a full feature on that microcap stock filled with hype and hyperbole.

Organovo subsequently fell from $14.00 to its current levels of $2-3 when it became apparent that the “3D printing of body parts” was pure fantasy. Thanks Pop Sci. In these cases above, there is certainly no evidence that this coverage was paid for. However, it has been my observation that anyone can obtain glowing media coverage if enough money is paid to a PR/IR/Media agency. Given that millions of dollars have already been paid to stock promoters, it should come as no surprise that aggressive media placements have proliferated covering Cemtrex and the Govils. Irth was founded by brothers Andrew and Robert Haag. The Haag Brothers had both previously worked for small cap investment bank Auerbach, Pollak & Richardson. Auerbach folded in 2001 after its securities registration was revoked following a variety of regulatory violations. In 2002, Andrew Haag then went to work as CFO and director of microcap reverse merger Quintek Technologies, a former Auerbach client. In 2002, Quintek’s CEO was sanctioned by the SEC for having put out a variety of false and misleading press releases regarding phony purchasing orders, causing the stock to soar dramatically, coincidently just as the company was looking to raise money. Haag stayed on with Quintek until 2008. He notes that as CFO, he “Raised $5 + million in capital, Increased Valuation + Liquidity, Expanded Shareholder Base 10 fold, Responsible for Cash Management, Responsible for Public Filings, Corporate Development”. But we can see that by 2008, the SEC was already hounding Quintek for putting out delayed financials which contained material inaccuracies (ie. Just like Cemtrex). These financials then needed to be publicly restated. As CFO, Hagg stated to the SEC that he would be retaining a PCAOB audit firm to rectify the inaccuracies in the financials. But instead, the members of management simply resigned and Quintek stopped making further SEC filings. Quintek just went dark leaving investors with nothing.

Following the implosion of Quintek, Haag and his brother then founded Hampton Growth Capital which focused on “Investor Relations” and “Capital Formation“. Like Chardan and Source above, Hampton placed a heavy focus on servicing Chinese reverse mergers, helping to promote them so that they could raise money from US investors. By 2011, following the wave of fraud among Chinese reverse mergers, Hampton’s Chinese reverse merger clients had been completely delisted. With Hampton in disgrace, the Haag brothers then ceased using that name began using a new name, “Irth Communications”, and promoting US based micro caps.

Below you can see the stock performances of some clients of Irth Communications. You can see that most of these have imploded by as much as 90% from their highs following the promotion.

For those who wish to check on their own, you can see that most of these Irth clients happen to also have been the subject of heavy paid promotion including via our favorite promoter group SCS. Checking this is easy by simply going back to Hotstocked.com or Stockpromoters.com.

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Point #5 – Financial and disclosure “irregularities” and inconsistencies

Given the state of Cemtrex’s auditors and bankers, seeing blatant errors, “irregularities” and inconsistencies should come as no surprise. But as I have shown repeatedly in past articles, when we see such repeated irregularities in a company’s SEC financials it generally presages an implosion in the share price and/or a delisting of the stock.

Anyone who has performed a detailed review of Cemtrex’s SEC filings should know that Cemtrex tends to play very fast and loose with its SEC reporting requirements.

The filings that Cemtrex is required to make have been late, they have been inaccurate, there have been blatant inconsistencies between various filings that are never reconciled.

This includes even the most major filings such as the annual 10K and the Proxy. Cemtrex originally filed its previous 10K filing in December of 2015. Almost 9 months later, it was still filing amendments and corrections to correct blatant errors in that filing. The mistakes included very major items, such as the details of its liquidity position, as well as many minor items such as various spelling and grammatical mistakes which should never be found in a 10K.

The delayed and inaccurate filings are the reason why Cemtrex was forced to cancel its S3 equity offering in 2016, which was being run by Chardan Capital. Instead, Cemtrex was then forced to conduct a much more lenient rights offering, which would then be run by Source Capital Group. Rights Offerings can be completed even by those companies who become ineligible to do an S3 offering.

Because of this negligence / omission in SEC filings, Cemtrex was forced to disclose in the most recent 10K that:

We did not timely file with the SEC (NYSE:I) our definitive proxy statement, which includes the information required by Part III of Form 10-K, within 120 days of our fiscal year ended September 30, 2015, (ii) our Form 8-K in relation to our meeting of shareholders held on March 7, 2016, or (NASDAQ:III) several other current reports filed during the preceding 12 calendar months. All of these reports were ultimately filed, but their lateness caused us to become ineligible to use Form S-3, a shorter registration statement that is often used for “shelf” registrations. If we are not able to file our current and periodic reports and other documents with the SEC in the future in the times specified by the Securities Exchange Act, we will continue to lose our eligibility to use Form S-3 for future capital raises, and that could impair our ability to conduct more efficient and expeditious public offerings of our stock off of shelf registrations. Our inability to timely file current and periodic reports in the future could materially and adversely affect our financial condition and results of operations.

Examples

As we saw above, Cemtrex originally disclosed that it pays its CFO nothing. Later on, it quietly revises this previous disclosure after the fact and without explanation. The new disclosure indicates that this CFO of a $100 million revenue multinational is paid a mere $40,000.

And then next we saw how the number of shares of each and every member of management has declined substantially over the past year (during a paid stock promotion), even though none of them filed a Form 4 to disclose any sales.

So now let’s explore the issue of possible backdating of option grants by Saagar Govil, just before the paid stock promotion campaign really took off.

As we saw above, the bulk of the promoting campaign began in March of 2016.

In the 10Q released in May of 2016 Cemtrex discloses that:

On February 12, 2016, the Company granted a stock option to purchase 200,000 shares of Common Stock to Saagar Govil, the Company’s Chairman, Chief Executive Officer, President and Secretary. These options have an exercise price of $1.70 per share and expire after six years.

So, apparently by pure coincidence Saagar Govil happened to award himself 200,000 shares worth of options on the exact day of the exact lowest closing share price over the past two years ! So either Mr. Govil was preposterously lucky or else this looks a lot like options back dating. As we know, options backdating is quite illegal, as noted here:

Because publicly traded corporations must properly report the value of options on their financial statements, any backdating could result in a misstatement that can be the basis for a charge of securities fraud.

This becomes more of an issue when we look at the quarterly financials that Cemtrex filed with the SEC AFTER Feb 12, 2016.

In that 10Q filed in May of 2016 (3 months AFTER the options had supposedly been awarded), Cemtrex disclosed no change in “Share Based Compensation” for the quarter despite the 200,000 options which had supposedly been granted to Govil in February. By the time that quarter was reported, the share price had already risen by around 30%.

Upon receiving that options grant, Saagar would have been required to disclose it on Form 4. However, no Form 4’s were filed in all of 2016.

The second grant to Govil is just as curious. In the most recent 10Q filed with the SEC in February 2017, Cemtrex disclosed that it had awarded another 200,000 shares of options to Saagar Govil. It had noted that the options were granted on December 5th 2016, at a price of $4.25 per share.

Looking back from February 14th, 2017, we can see that again the week of December 5th again corresponded to the lowest closes for the stock over the preceding 3 months. Once again, Mr. Govil had impeccable timing.

What gets really curious again is the fact that when Cemtrex released the 10K on December 28th (i.e. AFTER the supposed options grant had already been given) the company only disclosed the earlier 2016 option grant and not the new one, supposedly made on December 5th. Again in January 2017, Cemtrex released its Proxy Statement. And again, the company only disclosed the earlier February stock grant to Govil. No mention was made of the December 5th options grant.

And just as in the past, Saagar Govil never filed the REQUIRED Form 4 to disclose the new shares given to him.

In January, the stock really took off. By the time Cemtrex disclosed the new options grant to Govil, the share price had repeatedly broke through new highs north of $7.00 and had briefly exceeded $8.00, such that backdating the options just before releasing the 10Q could have resulted in as much as $800,000 in instant profits for Saagar.

These discrepancies are particularly notable given what we have seen with the auditor and the CFO.

Cemtrex directors

Separately, we can also see that Cemtrex’s outside board members consist of Shamik Shah and Sunny Patel. Both of these individuals are young hedge fund traders who focus on trading stocks, futures and/or derivatives. They show no experience in anything related to running a public company, engineering or environmental controls or accounting issues. They have no business being directors of Cemtrex, aside from potentially around issues regarding trading the stock.

Just like Saagar Govil, we can see that 30 year oldShamik Shah went to school in New York and graduated with his undergrad degree at exactly the same time as Saagr Govil in 2008.

Diretor Sunny Patel is also now 30 years old also graduated from the same school in New York in 2008 and also worked as a derivatives trader with a hedge fund.

Just like Saagar Govil, these two were brought on as directors for Cemtrex despite having no relevant work experience.

Both Shah and Patel were appointed as directors in April and May of 2015. That happened to be precisely when Cemtrex was applying to uplist from the OTC BB to the NASDAQ. As part of that process, the company is required to have outside board members, which is why Cemtrex appointed these two then 28 year olds with no relevant experience those roles. By fulfilling this simple requirement, Cemtrex was then able to uplist to the NASDAQ just a few weeks later.

Either way, as directors of a public company, these individuals are presumably now fully on the hook for any potential issues which may arise from any potential undisclosed paid stock promotion, auditor misrepresentations and/or selection issues, financial statement irregularities, back dating of options and etc.

HERE IS THE CONCLUSION !!

Based on the information laid out above, I believe the following:

I believe that it is highly likely that Cemtrex will face delisting and go to effectively zero.

Cemtrex management is paying for an undisclosed stock promotion via an undisclosed entity called Southern Steel & Construction. Aron Govil is behind Southern Steel & Construction, and that entity reports the same address as Cemtrex.

The promoters being paid include SCS, whose past promotions have imploded, been halted or delisted, including due to fraud.

During this undisclosed paid promotion, the Govil’s have actively encouraged investors to buy Cemtrex shares via social media. At the same time, members of management have been making large sales of stock without disclosing those sales on Form 4 as required by the SEC.

Cemtrex’s auditor (Bharat Parikh & Assoc.) is actually controlled by an individual (Mahesh Thakkar) who has been banned by the SEC and PCAOB as a result of multiple past audits, sign off’s or reviews which were fraudulent. Cemtrex’s auditor continues to report to the SEC that it is running its operations out of 4940 McDermott Rd., Plano, TX. Yet that location is actually a completely vacant strip mall. The phone number has been disconnected. According to Texas State records, the auditor is not even licensed to practice in Texas. Thakkar has run multiple different audit operations out of 4940 McDermott under various different names (including Thakkar CPA, The Hall Group CPA, TMK LP and now Bharat Parikh). Each one of the previous ones has been shut down. Thakkar then changes the name of the firm and keeps auditing the same clients, all from the same vacant address.

Cemtrex claims to generate nearly $100 million in revenues from subsidiaries across 4 countries and 3 continents. Such a company would normally expect $500,000-$1 million in audit fees per year. Yet Cemtrex pays Bharat Parikh a mere $15,000-$20,000 per year.

Cemtrex’s 3rd party service providers include Source Capital, Chardan Capital and Irth Communications. Each of these parties has a long and noticeable history of doing business with small cap stock promotions which have been promoted by SCS or the other promoters behind Cemtrex. There have also been past involvements with companies, individuals or activities with have involved imploded stock promotions or securities fraud.

Cemtrex’s filings repeatedly contain information which is either inaccurate or inconsistent between filings. Many filings comes extremely late. Many required filings have not come at all. It is clear that shares owned by members of management have declined substantially during the course of the paid promotion. Yet no Form 4’s have been filed to disclose sales to investors or the SEC. Past disclosure states that the CFO was working for years at zero salary from Cemtrex, while he was being paid by Aron Govil’s Ducon. Option grants to Saagar Govil occurred at times when the share price was hitting deep lows. These grants were not disclosed until after the share price had appreciated substantially. Earlier filings, which should have disclosed the impact of those new shares under the option grant, made no mention of the options until much later, after the share price had already risen.

Again, to me the case for fraud and delisting seems obvious.

Appendix A – past frauds or promotions by SCS which were halted, delisted or imploded

SCS clearly matches the exact type of promoter that the SEC is warning us about in terms of “microcap fraud” because numerous promotions from SCS end up getting quickly halted or delisted by the SEC. Examples of halted or delisted stocks from SCS have included:

Just like Cemtrex, each of these stocks surged by hundreds of percent following aggressive promotion campaigns by SCS promoters. Just like Cemtrex, each of these stock promotions had a very well crafted investment story specifically designed to lure in retail investors.

Each of these stocks were then halted or delisted outright when the SEC found financial irregularities or outright fraud.

So again, these are the exact promoters that Aron Govil is paying using an undisclosed entity in New York.

Both Hotstocked.com and Stockpromoters.com continue to list the paid promotions of these stocks which were run by SCS.

Just like Cemtrex, Code Rebel was being promoted by SCS as an acquisition play. Paid promotion and press releases around the acquisition hype caused the stock to surge by several hundred percent shortly before it was delisted and went to zero.

Just days after the latest SCS promotion, The SEC noted that it had suspended trading in Code Rebel:

because of questions regarding the accuracy of statements in CDRB’s Forms 10-Q for the quarters ended June 30, 2015 and September 30, 2015, and the Form 10-K for the year ending December31,2015, concerning the company’s assets and financial condition. This order was entered pursuant to Section 12(k) of the Securities Exchange Act of 1934 (Exchange Act).

Similar promotion efforts by SCS caused Forcefield Energy to soar by hundreds of percent. In the case of Forcefield, the stock quickly fell by 60% immediately after my own article exposing the fraud. In fact, within just a few days of my article exposing the fraud, the stock was halted by the SEC and then delisted. It was a zero within just days.

At the time, the SEC noted that it was suspending trading at Forcefield:

due to concerns about the adequacy and accuracy of information available to investors concerning the funding of recent articles and promotions touting FNRG, including for example in articles published on December 9, 2014 and February 26, 2015. Questions have also arisen concerning potential manipulative activity of FNRG’s stock, including transactions between February 25 and April 2, 2015 and the funding of those transactions. This order was entered pursuant to Section 12(k) of the Securities Exchange Act of 1934 (Exchange Act).

For reference, here is my previous article on Forcefield, which I published when the stock was at $7.50 – just a few days before that suspension from the SEC.

Appendix B – Additional Cemtrex promotions

Here is a partial screenshot showing just a few of the recent promotions, click the links above to see dozens and dozens more. I encourage interested readers to go to Hotstocked.com or Stockpromoters.com to read more examples.

(click to enlarge)

These sites show that the promoters and payors behind Cemtrex include:

– Broad Street Alerts, Small Cap IR, and Small Cap Street (under the umbrella of Small Cap Specialists (“SCS”)

– Third Coast Media

– TSX Ventures

– Stock Market Leader

– Micro Cap Research

– Small Cap Leader

– Southern Steel & Construction

Despite the warnings from the SEC, there seems to be a never-ending stream of new retail investors who continue to fall for the well-constructed schemes of stock promoters. And aside from those stocks that have been halted and delisted, these promoters have been behind dozens of additional stock schemes which simply imploded to the pennies without ever being formally halted or delisted.

Appendix C – Looking at the short interest

The Govil’s have repeatedly made it a point to blame “the shorts” for any weakness in the share price and for any criticism that comes to their company or management. This is a very common diversionary tactic with stock promotions. Unfortunately, many naïve retail investors continue to fall for it.

But with Cemtrex, the math simply doesn’t add up. As of January 31st, there were only around 400,000 shares sold short, amounting to just over $2 million in total. This is virtually nothing. Cemtrex typically trades around 500,000 shares every day.

The short interest has also been steady at 100,000-400,000 shares for the past 6 months, such that there has been very little increase relative to the volume. Every share sold short could easily be covered within 1-2 trading days while having minimal impact on the share price. Likewise, the entire short interest of 400,000 shares would have minimal effect of Cemtrex’s share price over this time.

Here is the link to the NASDAQ showing short interest as well as a screen shot for your convenience. Note that the “days to cover” indicates that the entire short interest could be covered in a single day’s trading.

(click to enlarge)

SCS’s promotion of fraudulent Forcefiled Energy was just the same. Despite a very low short interest, Forcefield tried to distract retail investors by blaming its problems on evil short sellers. But this diversionary tactic from management didn’t slow the immediate 60% plunge in the share price of Forcefield. Clearly inside share holders were the ones selling big even as they were trying to persuade retail shareholders not to sell or to even buy more. But this would only be revealed once the subsequent criminal indictments came out against Forcefield Management.

For your reference, here is a press release put out by Forcefield Energy just after my article in which the Chairman accuses “the shorts” of disseminating false and misleading information. He also claims that he was initiating a regulatory investigation with the SEC to supposedly pursue “the shorts” in defense of his shareholders.

Instead, the Chairman was doing no such thing. Right as he was issuing press releases to reassure retail holders, he was actually in the process of attempting to flee the country while he was simultaneously dumping his shares. Within just days, he was arrested by the FBI as he attempted to board a flight to Central America. Forcefield’s stock was halted, going quickly to zero. The Justice Department later announced that 9 individuals were arrested and indicted on massive securities fraud charges behind the promotion of Forcefield.

I have frequently come across many similar examples of stock promotions who try to distract retail investors by diverting attention to “the shorts”. They all typically tend to end the exact same way (with a trading halt, a delisting or a simply share price implosion).

An unnamed fund affiliated with Chairman quickly dumped nearly all of its YRD shares following the new PRC guidance which made such guarantees illegal.

Recently leaked internal emails show that YRD’s Chairman is forcing parent company employees to make undisclosed USD purchases or be fired.

Note #1: Everything in this article represents solely the opinion of the author. Nothing herein comprises a recommendation to buy or sell any security. Information in this post has been obtained from sources believed to be reliable, including SEC filings from the company named. As always, readers should conduct their own research and form their own opinions and conclusions.

Note #2: Prior to publication, the author shared information and documents from below in a written report to the United States Securities and Exchange Commission.

– Predatory related party transactions benefiting parent company over US investors

PART A: INDUSTRY PREVIEW – P2P IN CHINA IS COMING UNRAVELED (YOU SHOULD HAVE KNOWN BETTER)

In just the last few days, US investors have begun to find out what Chinese investors have known all along. This information comes from two articles last week in the Wall Street Journal and the English language South China Morning Post over the past few days.

As I will show, the problems facing China’s P2P lending space are transparently awful. Investing in this space defies commons sense. But as I will show later, the problems specific to YRD are actually even worsethan the generic problems of the industry as a whole.

Just from a macro common sense perspective it is safe to say this: anyone dumb enough to be LONG on stocks with heavy exposure to China’s domestic credit markets should probably not be managing money. Evidence of China’s “default storm” is said to already be exacerbating a “recent spate of fraud” in the credit markets “amid a rout that has analysts predicting a record number of defaults in 2017″. Just look to Bloomberg, the WSJ, the New York Times, or any English language financial news journal covering China.

For the most part, larger US investors (and effectively ALL Chinese investors) have shunned YRDs ADRs. In terms of outside investors, only a few smaller “quant funds” continue to hold positions. These investors make their investment decisions based on “factor models” which focus on key headline metrics and NOT based on underlying fundamental research into the company.

The P2P lending space in China is something akin to a Ponzi scheme which is rife with fraud. This is NOT an overstatement.

This is why China investors have shunned the space and why Chinese securities regulators have made P2P IPOs so difficult to achieve in China. The regulators in China seek to protect Chinese investors. So instead, these P2P players from China are simply choosing to IPO in the US where various smaller investors can be lured into the stock.

YRD initially intended to raise $300 million in its NYSE IPO. A few months later, the IPO was only able to raise $75 million at $10. And then, even that tiny IPO traded down as much as 16.5% on the day of the IPO.

Seemingly nobody wanted to buy YRD at any price. Within months, the stock traded down to as low as $3.35 in 2016. In the IPO and the aftermarket, YRD has been unable to sustain any substantial investment from any major institutions and certainly no smart China money has shown any interest whatsoever in owning the stock.

During 2016, YRD continued to report loan growth which was downright explosive. (But so did every other P2P player in China’s rapidly booming P2P space). Accordingly, the headline metrics for YRD looked temptingly good. YRD appeared to present a low P/E ratio, strong revenue growth, huge return on equity, etc. This began to attract a number of US quant funds (shown below) to take numerous small positions based on their “factor models”.

Here’s where it gets interesting.

At the time of the lows, YRD stock was also supported by undisclosed buying by an unnamed fund affiliated with YRD Chairman Ning Tang. (Even as no major institutions and certainly no major China investorshave shown any willingness to own the stock at any price.) The purchases by this unnamed Fund would not be disclosed until 6 months later, and in fact the purchases themselves would not even be disclosed until well AFTER the Fund had already dumped its shares.

As a result of the quant momentum buying and the purchases by the undisclosed Fund, at one point, shares of YRD had risen by more than 10x from those lows. But they have now begun to falter, Shares of YRD are now down by around 50% from those highs reached a few months ago, even as loan growth continues to soar and presumably YRD’s apparent “profits” continue to get “better and better”. Over the past few weeks, the share price can’t seem to catch a bid from anywhere. Notably, the unnamed Fund has already dumped nearly ALL of its shares at higher prices.

However, to keep this in perspective, even at $20 the shares are still up dramatically from the $3 lows in 2016.

As I will show below, China’s securities regulators have deliberately made it much tougher for P2P players to IPO in China. They are seeking to protect Chinese investors. As a result, these P2P players simply turn to the US capital markets to raise money via IPOs.

Just last week, it was revealed by the English language South China Morning Post that Chinese P2P lender Ppdai.com would also choose to come public in the US. Like YRD, Ppdai’s expectations are ambitious and it hopes to raise $200 million from US investors. Additional players in the China P2P space such as Dianrong and China Rapid Finance are also expected to tap the capital markets.

Ahead of the Ppdai IPO, the SCMP article quite clearly comes across as a warning to US investors who might be tempted to invest in a Chinese P2P. The SCMP makes clear what Chinese investors have known all along. Here are a few quotes from SCMP, which again came out just last week:

– In China, “P2P lending…has been mired in a slew of scandals amid runaway investment and fraud since late 2015.”

– “Beijing will heighten requirements for P2P players…The intention of the heightened regulation is partly to shut down some firms that purport to be P2P lenders.”

– “dozens of unscrupulous players raised funds from depositors and then channeled the loans to corporate clients such as property developers.”

– “In 2015, Beijing-based Ezubao was found to have defrauded more than 1 million investors of about 100 billion yuan.”

The SCMP article came out last Monday. By Friday, we had a separate article from the Wall Street Journal which should serve to further warn US investors about the P2P space in China.

The firm highlighted by the WSJ is Cosun, a Chinese phone maker. Unlike the loans facilitated by YRD (which are effectively consumer to consumer), this was a corporate that had raised the money via P2P.

And the firm that facilitated the loans was Ant Financial, which is owned by giant Alibaba Group (NYSE:BABA). In other words, we are NOT talking about a small time player here. The problems in China’s P2P space have infected every corner of that market.

According to the WSJ, the investment process here is effectively the same as the process used by YRD and every other China P2P player.

A large number of small Chinese retail investors (in this case it was around 13,000 investors) log on with their smart phones and opt to make small investments in some sort of P2P loan product. There is no researchand no due diligence. They just click on their smart phone and then “poof” they have invested in something which is supposed to provide some attractive level of returns. Their money is transferred out of their bank account immediately and automatically.

As shown by the WSJ, the default

illustrates a rising risk in China, where hundreds of millions of people seeking higher returns on their savings have used their mobile phones to buy risky, unregulated investments.

Again, the P2P in this case was backed by China’s Alibaba, perhaps the largest and most prestigious name in Chinese ADR’s. YRD is certainly in a far lower league than Ant and Alibaba. At its lows last year, YRD was worth just $200 million.

And (just like we will see with YRD), the Cosun case looks like it demonstrates a clear example of outright fraud being the culprit. Notably, both Chinese and US investors have been victimized.

From the WSJ:

Other businesses owned by Cosun’s founder have faced accusations from U.S. and Hong Kong securities regulators that they engaged in dubious accounting. Three of his companies got delisted from stock markets in the U.S. and Hong Kong. He appears to have never responded to any of the claims.

It sounds like investors should have known better. But with no research being conducted during their quick smart phone process, this is what happens.

THE POINT:

The point of this so far: Investing in China’s P2P space is just downright dumb. You have already been explicitly warned by the SCMP and the WSJ. Chinese equity investors and regulators have known this all along. This is why the P2P players are dumping these ADR’s on US investors.

As we will see, the specifics as they apply to YRD are even worse.

PART B: SUMMARY OF YRD SPECIFICALLY

I have spent much of my adult life living, working and traveling in China. I studied Chinese at Peking University, which the Chinese often refer to as the “Harvard of China”. When in China, I spend most of my time in Beijing and I have often invested long and short in US listed Chinese stocks following my career as an investment banker in Hong Kong and New York.

There are certainly a few interesting US listed Chinese ADR picks. But as I’m going to show today, Chinese P2P lender Yirendai is actually a compelling short.

The last two problematic Chinese ADR’s I exposed fell by 50-90%.

Additional Chinese stocks I have exposed were subsequently delisted or became the subject of SEC investigations.

To fully understand the depth of the problems at YRD, there are a wide variety of points to be made. Some are very severe and urgent. Some are more along the level of just disturbing trends which are sharply worsening over time. For the sake of completeness, I am going to address all of these points and let the reader figure out which ones mean the most to them according to their own perspective.

PLEASE NOTE:

TO UNDERSTAND HOW EACH OF THESE PIECES FIT TOGETHER, IT IS IMPORTANT TO READ THIS ENTIRE ARTICLE. THE POINTS I MAKE ARE DELIBERATELY PRESENTED IN ORDER OF INCREASING SEVERITY.

At the end of this article, I will show an internal email from YRD’s Chairman Ning Tang to his employees at YRD parent Credit Ease which were posted on a site in China. According to those postings, effectively he is requiring employees to contribute their own personal money (required to be made in US dollars) into a fund which is buying “undisclosed” US equities (presumably shares of YRD). The order from Ning Tang is mandatory and he makes it clear that anyone who doesn’t personally buy into this is threatened with immediate dismissal. Yeah, it’s that bad.

I will also show how an undisclosed and unnamed “affiliated fund” of Ning Tang was aggressively buying shares of YRD at the lows last year, but then dumped effectively all of its shares right as new regulations loan guarantees (such as those by YRD) are in fact illegal. That fund dumped at prices well above current levels.

As a preview, here are the points which will be elaborated and substantiated below:

None of the usual China “smart money” (i.e. funds like Sequoia, Matrix, etc. ) are willing to invest anything in YRD. YRD’s Chairman still owns a large indirect stake in YRD, but other members of YRD management refuse to own any shares whatsoever. As I will show below, the reasons for this will become blatantly obvious.

Outside holders are primarily US based low fee quant funds who have made their investment selections based on superficial analysis of basic equity metrics such as stated “EPS growth”, stated “book value” and stated “gross profitability”.

These metrics, which appear to be positive on the surface, are only made possible by virtue of YRD providing a credit guarantee (which has recently been deemed illegal in China). Investors are clearly not pricing in the now extreme subprime credit risk. They have also not appreciated what will happen to YRD’s metrics when the now-illegal credit guaranteedisappears (which it is about to).

US listed YRD was actually spun out of parent company Credit Ease. Credit Ease originates fully 67% of YRD’s loans and takes a flat cut out as an origination fee. Credit Ease therefore receives substantial income with zero risk. By virtue of the guarantee, US investors in YRD bear all of the risk associated with the loans. It is a massive related party transaction which benefits the parent company over US shareholders.

YRD maintains the loans for the P2P investors. Because YRD guarantees the loans, Chinese retail investors (P2P lenders) accept a very low rate of return and YRD enjoys very high income (in the short term) while loan growth continues to be strong (in the short term).

YRD (the entity sold to US investors) is actually a dumping ground for deep subprime loans for parent Credit Ease. As a result, YRD has dramatically altered its business model. YRD has gone from making mostly prime “A Grade” loans in 2013 to almost exclusivelymaking deep subprime “D Grade” loans with APRs up to 40%. Default rates for C and D loans are already soaring by far more than expected. But (even more troubling) even the “prime” “Grade A” charge off rates have skyrocketed from 2% to 9%.

Given the level of distress in “A Grade” loans, we can assume the “D Grade” loans are going to be exponentially worse. And deep subprime “D Grade” loans now compriseover 80% of new loans !

In reporting “delinquent loans”, YRD cherry picks the 15-89 day past due metric which it cites as just 1.9%. But this is largely irrelevant since the defaults tend to occur after 89 days, as we can see. Defaults beyond 90 days can be seen to be clearly much higher. (YRD’s highlighted metrics can therefore be filed under #AlternativeFacts)

YRD pretends to have its own sophisticated credit scoring system. But the reality is that there is no national FICO system in China. YRD approves loans to deep subprime “D Grade” credits within just 10 minutes with minimal credit checks in an application process completed on a smart phone. YRD allows borrowers to “self declare” their use of proceeds.

In the past two quarters, YRD was forced to disclose the impact of significant “organized loan fraud” affecting already approved borrowers totaling over RMB81 million. After their initial discovery, these fraud amounts were larger than originally assumed and YRD was forced to write off 100% of the amounts in question.

In addition, the only “risk reserve fund” established to back these loans is deeply undercapitalized.

But it gets better. These loan guarantees made by YRD for P2P loans have been made illegal under new regulations in China. Despite the new ruling, YRD continues to offer guarantees, simply because it must. I do NOT expect to see YRD get hit by any massive penalties in China in connection with illegal loan guarantees. Instead, YRD will simply be forced to stop offering the guarantee.

But without such a guarantee, YRD will be forced to give investors a dramatically higher payout, crushing its heretofore attractive “metrics” of both profitability AND growth. The US based quant guys who own YRD ADRs clearly haven’t figured this out. (…yet.)

The new regulations also prohibit ties to asset management activities. Yet YRD is clearly tied to asset management firm Toumi. In fact, I will reveal leaked internal emails below which show that YRD’s Chairman is forcing employees of YRD’s parent to personally invest their own money, SPECIFICALLY IN US DOLLARS into the Toumi asset management platform be for the purpose of driving money into some unnamed US dollar stock. Employees who don’t comply and contribute their personal money to this investment scheme will be fired ! (Note that the only US dollar stock connected to the Chairman happens to be YRD).

Prior to the compulsory Toumi investment, I will also show how an unnamed fundaffiliated with Chairman Ning Tang was aggressively making undisclosed purchases of YRD ADRs last year, pushing up the share price when it was struggling. The fund then immediately began dumping effectively all of its shares of YRD just as the government announcement about illegal loan guarantees came out. No disclosure of the purchases was made until after the shares had already been dumped.

PART C: BACKGROUND

Following my exposé of Chinese advertising company Air Media (NASDAQ:AMCN) that stock ended up falling by around 50%. Air Media had touted that it was being bought up by an outside 3rd party, causing the stock to more than double. The suckers were largely US investors who didn’t do their research in Chinese.

But once I posted the Chinese language documents online (along with English translations), we could see that the transaction was just a sham. The stock returned to its pre-hype lows.

But that one was pretty easy.

Other China trades were actually a lot more interesting.

In the past I had highlighted a US listed Chinese ADR called Sungy Mobile (NASDAQ:GOMO), which then fell by as much as 90%.

Sungy came public at a price of $11.22. It then quickly soared to around $30, giving it a market cap of well over $1 billion. The underwriter on Sungy’s IPO was Credit Suisse, who continued to tout the stock with a $34 target. The company lacked much by way of current financial results, but CS was predicting transformative growth which would presumably justify the lofty valuation.

When I first raised the alarm on Sungy, the stock was still sitting at around $28. I illustrated clearly that Sungy’s underlying “product” was not in any way commercially viable. The “product” consisted of various app downloads for one’s phone such as ways to customize the background wallpaper. Yes, it was really that bad. Sungy also had document reader app, which primarily competed with free offerings from software providers. Again, it was a pretty much nonsense of a product and it seemed hard to believe that anyone would fall for it. But there were a few buyers of the stock following the IPO. Ongoing support from the sell side and macro bullishness towards China elevated the stock price to irrational levels. In hindsight, it was obvious. (But then again, it is always obvious in hindsight….)

Following my article, Sungy began a rapid and steady downward trajectory, quickly hitting $12. The implosion picked up speed when each new deeply disappointing quarter showed that failure was inevitable.

The decline picked up even more speed and soon Sungy was down to $2-3. At this time, Sungy management simply took the company private, buying back all of the shares at around $5. It was quite a nice scam. Sell the shares to US investors at $11.22 and then buy them all back a $5 a little while later, keeping all of the cash and the remains of the businesses.

As we can see, Sungy isn’t the only Chinese company to foist a bad businesses upon unsuspecting US investors.

PART D: OVERVIEW ON YRD’S P2P LENDING ACTIVITIES

Yirendai (“YRD”) is a Chinese P2P lender, analogous to Lending Club (NYSE:LC) in the US.

Like YRD, Lending Club initially saw its day in the sun as investors flocked to the novel idea of P2P lending. But then a series of shady activities by management (originating undisclosed loans to employees to boost volume) along with revelations of very bad risk management sent the stock down by around 80% from $25.00 to around $5.00.

This is exactly what we will see with YRD. Keep in mind that loan volume has continued to grow strongly at Lending Club, just like it has at YRD. But apparently originating more and more bad loans is not something that ultimately supports a strong share price.

It did not take long for Lending Club to fall by 80%.

(click to enlarge)

Like Lending Club, YRD simply acts as a middle man. YRD connects willing retail investors (lenders) in China to willing borrowers in China. The lenders make loans to the borrowers via YRD’s platform and YRD sits in the middle and collects a spread.

In China, the growth of P2P lending continues at a torrid pace as small loan investors (lenders) continue to seek decent returns on small amounts of cash while consumers have shown they will continue to pay APR’s of up to 40% to take on loans which are becoming well beyond their financial means. In many cases, these the purpose of these loans is just to pay for consumer luxuries like cosmetic surgery or expensive vacations.

Along with the boom in P2P in China, there are a number of emerging concerns about the industry.

Keep in mind that such easy credit was not available in China during the global credit implosion of 2008-2009. Much of the reason that China stayed strong and stable following that US led crisis was that Chinese consumers had very little debt and lots of cash.

This arrival of unchecked easy credit in China is a new phenomenon which has largely been ushered in by P2P lending.

In August of 2016, Guo Guangchang, Chairman of Fosun International, told Bloomberg News that China’s peer-to-peer lending industry is “basically a scam,” arguing that players in the multi-billion dollar sector, troubled by collapses and frauds, lack the ability to price risk.”

In December 2015, the country’s biggest Ponzi scheme was exposed after Internet lender Ezubo allegedly defrauded more than 900,000 people out of the equivalent of $7.6 billion. China has 1,778 “problematic” online lenders, according to the banking regulator.”

And the stories continue to get more bizarre. Even last month (December 2016), Chinese regulators continued to raise concerns about other P2P abuses such as lenders requiring young girls to send naked “selfies” of themselves in order to receive P2P loans. Once they obtained the naked photos, the lenders then extorted the young women, threatening to publish the photos online.

The picture that quickly emerges of China’s P2P industry is one of a financial “wild west” which lacks sufficient regulations, controls and protections. In the absence of appropriate regulations, some P2P lenders have shown explosive growth via the use of deeply reckless practices.

(Think back to 2007 in the US when anyone involved in the mortgage industry was making a fortune by signing up volumes of new borrowers who clearly had zero ability to repay what they were borrowing.)

And now the situation in China P2P is actually changing, both from the industry side and from the side of the capital markets.

On the capital markets side, we can see from October 2016 that P2P players who want to go public are now less able to do so in China. They are being forced to sell their shares into foreign markets rather than to Chinese investors:

Due to regulators issuing stricter rules on online lending in October, A-shares are no longer considered favorable for P2P IPOs, likely driving P2P companies to list overseas.

In other words, because China’s regulators have determined that P2P companies are not suitable for Chinese investors, these companies are simply turning around and selling shares to US investors.

Keep in mind that over the past few years, many US listed Chinese companies actually took their companies private, LEAVING the US capital markets to get a much higher valuation by listing in China. But for the problematic companies that can’t list in China, deep pocketed US investors remain as a viable alternative. Valuation is simply not relevant. Completing the IPO at any price is all that matters.

As we will see, this is one clear reason why we see none of the usual “China Smart Money” involved in YRD. It also likely explains why we do not see any ownership by YRD management outside of founder Ning Tang’s legacy position.

This will be illustrated more clearly below.

(click to enlarge)

PART E: WHO DOES OWN SHARES OF YRD ? WHO DOESN’T OWN SHARES OF YRD ?

Both of the questions above are equally important.

First, let’s look at insiders.

From YRD’s 20F, filed in April 2016. We can see founder and Chairman Ning Tang owns 40.2% of YRD. This stake is owned indirectly because the shares are actually owned by Credit Ease, which is YRD’s parent company. Ning Tang is founder, Chairman and CEO of Credit Ease and via that ownership, he indirectly owns the shares of YRD. Ning Tang does not directly own any shares of YRD.

As described in a section below, Tang’s ownership then increased and decreased slightly as an “affiliated Fund” bought shares and then later sold them.

As we can see, from the 20F filed in 2016, no other member of management is willing to own shares in YRD.

(click to enlarge)

Each of Ning Tang, Huan Chen, Tina Ju and Yihan Fang hold significant roles as either executives or directors at parent Credit Ease. But as shown above, NONE of them aside from Ning Tang are willing to own shares in YRD.

Next, let’s compare YRD’s shareholders to what we normally see with the higher quality Chinese ADR’s listed in the US. Obviously what we are looking for is the presence of the “China Smart Money”.

As I have demonstrated clearly in the past, US investors who play US listed Chinese ADR’s often have very little idea about what they are investing in. The “safe way” to play the Chinese ADR’s is to invest alongside the “Chinese Smart Money”. By this I refer to a small group of China based that always seem to have perfect timing and much better information than everyone else. They make much more money than anyone else and they often act in the same way at the same time.

At the top of that list we usually find Sequoia Capital. When US listed Chinese companies were going private in record numbers in the past, Barron’s suggested that the smart way to play China was just to follow what Sequoia was doing, noting:

The other “usual suspects” in China, such as Matrix, IDG, Shunwei and CITIC are also present in many of the most notable Chinese ADR’s.

So what do we see in YRD ?

Here is the most recent list of top outside investors in YRD.

(click to enlarge)

Here are the things that should stick out to you.

#1 – Precisely none of the usual “China Smart Money” have any interest in owning YRD. That’s a bad sign for YRD. Ordinarily one would expect to see several of the top China funds invested in such a US listed China ADR.

#2 – There are no funds whatsoever that have taken any substantial portion of YRD (i.e. absolutely no outside 5% holders)

#3 – No fund listed has a significant portion of their fund invested in YRD

#4 – The few funds that do hold positions in YRD are clearly “quant funds”

Items #1-#3 above speak for themselves. No one in China or outside of China has been attracted to make any significant investment in YRD in meaningful size.

But item #4 (the involvement of quant funds) requires a closer look.

The list above shows that the largest investors in YRD includes: AJO, Numeric Investors, Acadian and Nepsis. As can be seen from each of their websites, these are clearly “quant funds”.

For example, on its website, AJO notes that:

Because the market is complex, opportunities are best exploited with a systematic, quantitative approach. We use modern investment technology and academic research to complement the wisdom of classical investment thinking and analysis.

My point (as I see it) is that quant funds tend to be diversified investors which charge low fees. As a result, they cannot afford to do deep research on each of the names they invest in. This is why they have no idea about the problems that I am unveiling today.

Here we can see the various “factors” that have likely led this type of quant fund to invest in something like YRD. The following comes from AJOs website.

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Looking at the “factors” above, it now becomes clear why a presumably smart quant fund like AJO would invest in something as awful as YRD.

The reality is that if a bunch of smart guys at a fund like AJO consistently pick the right factors, then over time they will likely have better than average returns across their large and well diversified portfolio. But once in while they are going to have individual positions (such as YRD) that get obliterated because investing blindly in the superficial numbers will often not reveal deeper underlying problems that are found through in-depth research on a single name.

PART F: SO HERE’S WHERE QUANT INVESTING GOES WRONG

(Note that YRD deliberately cherry picks the 15-89 day delinquency rate as a proxy for bad loans. YRD discloses this metric at just 1.9%. I view this as an example of #AlternativeFacts. The data from this section below are taken directly from other disclosures by YRD. Even a cursory analysis of the disclosure shows that the situation with its subprime loans is quickly imploding from quarter to quarter. But as I see it, the low fee quant investors simply do not have the incentive structure in place to merit conducting this type of analysis.)

YRD has switched from making “prime” loans to almost exclusively making very deep
“subprime” loans.

When YRD first began making loans in 2013, it was making fully 100% of them to “A Grade” loans. This created several difficult constraints for the company.

First, the size of the pool of total borrowers who are “A Grade” is much smaller than the overall market of lower credit borrowers.

Second, “A Grade” borrowers don’t really have the need to borrow small amounts of money for discretionary purchases (after all, that’s why they are “A Grade” borrowers….). So their demand for loans is quite small.

Third, “A Grade” borrowers have plenty of other credit optionsavailable to them, such that one can only charge them a much lower rate of interest at up to 17% at best. But keep in mind that much of that 17% goes to the actual end investor (the lender on the YRD platform). YRD keeps only a portion of this as a fee. For “A credit loans”, the fee to YRD amounts to just 5.6%.

As a result of these issues, YRD was initially only able to generate a small volume of loans and was only able generate a very low level of return. In fact, because of the low 5.6% fee level, YRD disclosed that:

Grade A loans have an average transaction fee rate of 5.6%,which is lower than the average transaction fee rates for our other grades of loans, any failure to achieve a low default rate for our Grade A loans will diminish our profit margin and may even cause us to incur losses. Historically, Grade A loans have been unprofitable.

Clearly there was only one solution: Switch to subprime lending

YRD continues to disclose that it only lends to “prime” borrowers. But this is quite provably not the case. The overwhelming majority of new loans are being made to borrowers with “D Grade” credits and where APR’s run as high as 39.5%. This is quite obviously deep into subprime territory; there is nothing remotely “prime” about a short term loan with a 39.5% APR.

Starting in 2013, YRD was making 100% of its loans to “A Grade” borrowers. But by 2015, more than 80% of these borrowers were now “D Grade” credits.

The reason is obvious. “D Grade” borrowers pay up to 39.5% APR on their loans. This allows YRD to keep a much higher spread of 28.2% on these loans. In other words, YRD makes around 5x as much on “D Grade” loans as it does on “A Grade” loans. It also helps that the total demand for “D Grade” is multiples higher than the tiny demand for “A Grade”.

The result is that with subprime YRD switched into a massively larger target market whose profitability is 5x higher.

FastTrack loans are a new, fast expanding product that is currently only available through our mobile applications. These loans can be as large as RMB100,000 (US$15,437).

In 2014 and 2015, the average FastTrack loan amounts were RMB36,328 and RMB39,458 (US$6,091.3), respectively.

To apply for a FastTrack loan, a borrower completes an online application providing their PRC identity card information, e-commerce account information, mobile phone number and a credit card statement as well as the desired loan amount and duration. This product offers near instantaneous credit approval, allowing qualified borrowers to receive an initial decision in as fast as ten minutes.

Fast track is important because it means the following (in contrast to traditional P2P loans):

No verification of income

No verification of bank statements

Relies only on ecommerce statements and credit card statements

Approval in as fast as 10 minutes via smartphone

But how to entice lenders to lend to such visibly weak credits ?

Clearly lending to a Fast Track “D Grade” credit is a much different proposition that lending to an “A Grade” borrower. As a result, many investors on YRD’s platform would likely be unwilling to lend at all. Those that are willing to lend would demand a much higher rate of return.

YRD came up with a simple solution: provide a guarantee to investors that they will get their interest and principal repaid.

Even in years past, P2P lenders in China were not really supposed to be providing guarantees to lenders. As a result, YRD discloses to US shareholders that it does not provide guarantees on interest or principal. But in the past, it hadn’t really been codified into law during the nascent phase of P2P development.

Yet in the lending contract which it provides to lenders in China, we can see quite clearly that a guarantee is explicitly part of the lending contract. (See specifically clause 2.4).

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The existence of an explicit guarantee should also be 100% obviousjust by looking at the rates that YRD offers to lenders. This part requires no translation as the meaning is universal in any language.

From the following table, we can see that the rate lenders receive is identical regardless of whether the loan is being made to an “A Grade” credit or to a “D Grade” credit. The only variability shown in the rates is due to differences in maturity of the loan, where longer dated loans bear a slightly higher rate of interest (regardless of credit quality).

The following table comes from page 57 of the 20F.

(click to enlarge)

The only reason that investors are willing to accept the same rate of return regardless of credit quality is that the loan is guaranteed. Duh !This is basic finance 101 which should be obvious to any undergrad business major.

The table below shows the explosion of loans and apparent short term revenues and profits that occurred once YRD switched from prime “A Grade” loans to deep subprime “D Grade” loans with guarantees.

FY 2013

FY 2015

Increase

YRD Loan Volume

$42.7 million

$1.5 billion

35x

YRD Revenue

$3.1 million

$209 million

67x

YRD Net Income

($8.3 million) loss

$43.8 million

And in fact, the explosion in deep subprime loans has continued even through Q3 2016. More than 80% of loans continue to be made to “Grade D” borrowers.

But here are the two critical problems with providing loan guarantees

Problem #1 – Loan defaults are soaring and the “risk reserve fund” is deeply under capitalized

The actual amount of the risk reserve fund is not exactly clear because YRD has made contradictory disclosures in recent earnings calls.

On the Q3 call, YRD noted that:

As of September 30, 2016, the outstanding balance of liabilities from risk reserves fund guarantee is at 7.6% of the remaining principal of performing loans covered by risk reserve fund, up from 7.2% in Q2 2016

But this doesn’t match what was said on the Q2 call:

As of June 30, 2016, the outstanding balance of liabilities from risk reserve fund guarantee is at 6.7% of remaining principal of performing loans, up from 6.5% in Q1 2016.

The fact that these numbers are changing (for the worse) after the fact is obviously problematic. But the precise number isn’t what’s important. What matters is that the number is apparently around 7%, which is far too low given the soaring rate of “charge off’s”.

Anyone who actually cares can see that “charge offs” are accelerating at a much faster rate – EVEN AMONG “PRIME” LOANS WHICH ARE DEEMED TO BE “A CREDITS” !

(click to enlarge)

If we look at loans by age, “A Grade” loans which are around 3 years old are now being charged off at a rate of 9%. And that is for the highest credit loans on the book !

It is unquestionable that we are going to see much higher loan charge off rates for deep subprime “Grade D” loans which now comprise more than 80% of all new loans.

“D Grade” loans are a much newer product so there is far less historical data. We can see the charge off rates accelerating dramatically over the period of just several months.

The regulatory changes in China’s P2P lending market had been building for some time. Then in August 2016, it was announced that:

China’s banking regulator unveiled aggressive measures to restrain the country’s fast expanding peer-to-peer (P2P) lending sector on Wednesday, warning that almost half of the 4,000-odd online lending platforms are “problematic”…. Beijing’s hands-off approach to promote the sector as a form of financial innovation has led to a rash of high-profile P2P failures, scandals and frauds.

YRD’s share price quickly dropped by around 48% from $38 to around $20 before being bid back up briefly into the high $20s. It is now struggling to stay above $20.

CCTV (formerly China Central Television, now known as China Global Television Network) is the English language mouthpiece of China’s Communist Party. The outlet was quick to point out very explicitly that:

The regulations also ban P2P firms from providing guarantees for investment principal or returns, a common marketing practice to lure funds from unsophisticated retail investors.

“Investors must understand they need to bear the risks for their investments, no matter big or small,” said Li from the CBRC.

These are not deposits. So we are telling P2P investors: P2P is risky, investments need to be cautious.

So it could not be any more explicit. P2P firms are “banned” from providing guarantees for investment principal or returns (interest).

YRD management was quick to assure its US investors via English language news media that it was fully compliant with the new rules and that so called “risk reserve funds” were allowed.

Again. #AlternativeFacts.

As we have already seen, YRD is providing explicit guarantees. This is visible in its Chinese language contracts with lenders. It is also 100% observable via the uniformity in returns provided to investors across vastly different credit grades.

So to be clear: YRD is explicitly providing guarantees, which is illegal in China. Period.

Ok, so now the question becomes “so what”.

I do NOT expect that the regulators are going to swoop in and shut down YRD.

Instead, the problem is that YRD will soon be forced to stop providing those guarantees. Period. End of Story.

In my view, when that happens, there will be two consequences which will immediately shatter the factor models of the few “Quant” investors who currently own YRD’s ADRs.

The first consequence is that new loan volume is going to shrivel up immensely. There is a huge demand to lend money to what is perceived as “risk free” borrowers. Anyone with a bit of extra cash on hand can sign up on the platform and start generating income with virtually no (perceived) worry of repayment. These loan investors are rightfully treating these guaranteed investments as “deposits“. And this is exactly what the government has warned against.

As soon as the paradigm shifts to one of lending money to deep subprime “D Grade” borrowers who were Fast Track approved in just 10 minutes so that they could get some plastic surgery that they can’t afford anyways…well…I expect the collective desire to lend huge sums of money will shrink by at least 80%. That much should be quite obvious.

Of the potential investors who do choose to participate in such a market, they will obviously (and rightfully) require dramatically higher returns which will close in on the 39.5% that YRD can currently charge such subprime borrowers.

As a result, I expect that the 28% “spread” that YRD enjoys is also going to largely evaporate.

In fact, with lenders demanding to get compensated for the risk, we are likely to see YRD’s realizable spread fall to around the same levels that we saw for its realizable spread on “A Grade” loans. This just makes common sense. YRD was getting lenders to make “A Grade” loans to “A Grade” borrowers, such that the pricing was quite efficient. There was a clear limit to the spread that could be charged without driving borrowers and/ or lenders to more efficiently priced platforms. Once we see YRD facilitating “D Grade” loans to “D Grade” borrowers, the same market efficiency issue will come into play.

And as we saw above, YRD already disclosed that the spread it makes on “A Grade” loans is not enough to be profitable. YRD actually loses moneyon “A Grade” loans when accounting for admin and marketing costs.

Here is how to wrap your head around the new paradigm shift:

In the past and up until now, YRD has been providing an undercapitalized and illegal guarantee to lenders so that it could pay them artificially low (i.e. perceived as nearly “risk free”) interest rates when they lent out their money. But the borrowers of this money then paid full market (i.e. “risky”) rates of interest. YRD sat in the middle and collected the enormous “vig”.

Because the rate that lenders required was always fixed at very low levels, the obvious choice for YRD was to lend to whoever it could extract the highest rates from. Obviously this means lending to the worst credits possible.

On paper (and in the models of US quant investors), this all works fine in the short run. It looks as if the company is minting ever increasing amount of profits. Loan volumes are soaring and net income is soaring even more. And that is all great. But only in the short run.

In reality. this is no different that if my grandma in Boca Raton began selling hurricane insurance out of her basement to as many people as possible. Sure, she is bringing in a fortune in premiums in the short term. But she is selling insurance that she is unable to cover as soon as an “event” occurs. These economics are similar to what we see with YRD. And just as with P2P loan guarantees in China, this is why it would be illegal for my grandma in Boca to provide such a service.

PART G: YRD IS A SUBPRIME DUMPING GROUND FOR PARENT COMPANY CREDIT EASE

The reality as I see it is that YRD has largely been set up as a dumping ground for terrible subprime paper, foisting the future losses on oblivious US investors who are relying on superficial factor models.

IMPORTANT:

After reading below, it will quickly become clear why the “China Smart Money” won’t touch YRD.

It will also become clear why YRD and other P2P players are listing in the US rather than China.

It will also become clear why YRD management refuses to own shares in YRD itself.

YRD’s parent is Credit Ease, which is engaged in a variety of micro finance, inclusive finance and wealth management activities.

It turns out that most of YRD’s business is in reality a giant related party transaction with parent Credit Ease.

Credit Ease “originates” around 2/3 of the loans that go to YRD.

(click to enlarge)

Credit Ease charges a 6% fee off the top for originating, which was recently increased from 5%.

Keep in mind that Chairman Ning Tang doesn’t need to care so much about what happens to US listed YRD because he is actually the largest shareholder of Credit Ease and that’s where the real money is.

YRD discloses that:

Our agreements with CreditEase may be less favorable to us than similar agreements negotiated between unaffiliated third parties.

The slice going to Credit Ease is by far the most attractive part of the business model. Credit Ease takes its 6% cut on a huge volume of low quality loans, with zero risk, and then walks away. Regardless of what happens in the future (defaults etc.), Credit Ease makes a fortune. Clearly Credit Ease is strongly incentivized to maximize total loan volume without any consideration for credit quality. And this is exactly what YRD is doing.

US listed YRD is the middle man between these borrowers and lenders. And US listed YRD is also the one guaranteeing the exploding volume of loans being made to the lowest rung of subprime borrowers. Again, these are “D Grade” borrowers who are paying up to 40% APR. With Fast Track approvals, we can see that there are minimal verification requirements, including some which simply use the “honor system” for borrower disclosures.

P2P platforms (including) YRD typically prohibit borrowers from taking out more than one simultaneous loan. But there is no way for any of the P2P lenders to check and see if borrowers are taking out multiple loans from multiple different P2P lenders at the same time. So YRD relies on the “honor system“.

When granting loan approvals, the “use of proceeds” is also taken into consideration. For example, borrowing to make lasting improvements to one’s home would be given higher preference than, say, getting plastic surgery. But YRD has no way to verify use of proceeds, so it again simply relies on the “honor system“.

In both Q2 and Q3, there were several muted references to the massive spike in loan fraud that had hit YRD, notably in the Fast Track segment.

On the Q2 conference call, CFO Denis Cong noted that

Recently, in early July, during our regular credit underwriting process, we have discovered potential credit card statement fraud behavior from certain group of applicants for certain type of our online fast-track loans. We stopped offering this product and conducted immediate investigation. After thorough study and analysis, including systematic data checks and in person offline investigation works, we have preliminary concluded that there is likely an organized fraud incident that impacted on a group of approved borrowersmainly in early July with total contract loan volume of RMB72 million.”

In the follow up Q&A, Cong admitted that the company was writing down the full amount of this loss due to fraud.

And then by the time Q3 rolled around, we learned that YRD had actually underestimated the amount of the fraud. In Q3, YRD disclosed that the amount had now increased to over RMB81 million, roughly 15%.

In fact, I expect to see further escalation of loan fraud once we see Q4 as a result of YRD’s increasing use of Fast Track approvals to give easy credit with minimal credit checks within just 10 minutes.

PART H: Additional illegal activities at YRD

The illegal activities in this Part are not a dominant part of the equation in terms of YRD’s financial picture.

But I see them as necessary to understanding the bigger picture as we segue into the next section on potential trading irregularities in YRD ADR’s

In a report from global law firm Linklaters from August 2016, the firm made clear that under the newly released regulations from China’s CBRC, there P2P players were specifically prohibited from engaging in 13 categories of activities, including:

“Creating Asset Pools”

“Providing Guarantees” for borrowers

Selling “Wealth Management” products

From the sections above, it should already be clear that YRD is providing explicit guarantees. This is beyond any doubt. (regardless of what #AlternativeFacts YRD chooses to state).

Mr. Cong assured that CreditEase and Yirendai were “in full compliance” with the new requirements, and that the two companies were in “close discussions” with CBRC ahead of yesterday’s announcement.

(Note, in the Part below, we’re going to look at that quote again in the context of the TIMING of the sales by an affiliated Fund.)

But from what I see, YRD is also clearly “Creating Asset Pools” via its creation of a trust which invests in the loans that it facilitates. This trust was established in 2015 in an attempt to expand to institutional investors. The structure is convoluted: The trust invests in loans made through the YRD platform using funds from its sole investor, which is also the beneficiary. The name of the beneficiary is Zhe Hao Shanghai Asset Management Company, which happens to be an affiliate of Credit Ease. In April 2016, Zhe Hao then transferred beneficiary rights to a CICC “Special Purpose Vehicle” which intends to list on the Shenzhen Exchange and issue asset backed securities. In other words…. YRD is “Creating Asset Pools”.

In addition, YRD can also be directly linked to asset management firm Toumi.

Here is a screenshot of the website for iToumi.com. I have added a few translations in red. There should be no doubt that this is a Chinese asset management platform. We can also see the name Credit Ease, so that should not be in doubt either.

(click to enlarge)

But a closer look reveals that iToumi.com is actually being administered by Yirendai (“YRD”), not by Credit Ease.

Here is a snapshot of the WhoIs lookup for the iToumi.com website as it was shown a few months ago.

Obviously engaging in illegal activities is not a good thing in general. But in these two cases, the creation of trusts and the wealth management activities are not really such a big deal by themselves.

Instead, it is their links to the other activities below that are cause for much greater concern for me.

PART I: TRADING IN YRD SHARES BY AN UNDISCLOSED “AFFILIATED” FUND OF NING TANG

Following the IPO of YRD in December 2015 and then through 2016, there were issued a series of opaque and contradictory 13D’s which describe various purchases and sales of YRD shares by an unnamed “Fund” which is “affiliated” with YRD Chairman Ning Tang.

A fund affiliated with Mr. Ning Tang (the “Fund”) purchased 1,500,000 ADSs offered in the IPO at the initial public offering price for a total price of US$15,000,000 and on the same terms as the other ADSs being offered in the IPO. The funds used to purchase the 1,500,000 ADSs were invested by third-party investors. Mr. Ning Tang disclaims beneficial ownership of all of the ADSs purchased by the Fund except to the extent of his pecuniary interest therein.

OK. Fine. So Ning Tang “disclaims beneficial ownership” of the shares AND he notes that the funds were even provided by third party investors.

But then the 13D contradicts itself later in the filing, noting that:

After the purchase made by the Fund in the Company’s IPO, Mr. Ning Tang’s beneficial ownership in the Company increased to 46,430,000 Shares, representing approximately 39.7% of the total issued and outstanding Shares…The 46,430,000 Shares beneficially owned by Mr.Ning Tang comprise (NYSE:I) 43,430,000 Shares beneficially owned by Mr. Tang through his indirect holding of 43.4% of the total outstanding shares of CreditEase on an as-converted basis and CreditEase’s holding of 100,000,000 Shares in the Company, and (ii) 3,000,000 Shares represented by 1,500,000 ADSs owned by the Fund.

So in fact, the shares being purchased by “the unnamed Fund” are actually beneficially owned by Ning Tang.

Here is why that becomes important.

First, there were more purchases of YRD being used to support the stock when it was hitting new lows in March of 2016. Yet there was no disclosure of these purchases until 6 months later.

Those disclosures quickly become problematic.

Only in September did we see disclosure from YRD that in March (6 months earlier), Ning Tang’s unnamed “Fund” purchased an additional 300,000 ADS’s on the open market. This would have been done at around prices of $10 or even below.

These purchases were made between March 22nd and March 29th.

But by the time that filing came out in September, Tang’s fund had already begun dumping those shares, again without timely disclosure.

Between August 22nd and September 7th, Tang’s Fund sold all 300,000 of those shares acquired in March, as well as an additional 300,000 shares.

So we didn’t even know about the purchases until well AFTER the shares had already been dumped (along with hundreds of thousands more shares).

Then in a subsequent 13D from two weeks later in September revealed that the fund continued to dump a further million shares.

By this time, the Fund had now dumped around 90% of its holdings.

What is important to note here is that the Fund acquired its shares when the stock was hitting new lows and the buying served to prop up the share price in March.

But then the Fund quickly began dumping around 90% of its shares within a few weeks – within 24 hours of the new regulations being announced in China which outlaw the loan guarantees being used by YRD. Not surprisingly, the share price quickly took a significant dive.

(click to enlarge)

In the graph above, you can tell exactly when the announcement occurred in August, because that is what sent YRD plunging from its all time high near $40. You can also see that that is exactly when the Fund began liquating 90% of its shares of YRD.

SINCE THAT PEAK, SHARES OF YRD HAVE NOW ALREADY FALLEN BY 50% !

Again, Chairman Ning Tang has disclaimed his beneficial ownership of these shares, but from the 13Ds we can see that this is clearly not the case.

Perhaps of greatest importance is the fact that the Fund was began dumping 90% of its shares of YRD virtually simultaneouswith the public statements by the CEO and CFO which assured US investors that YRD had no issues with the new regulations which made its loan guarantees illegal in China.

The selling began just days BEFORE the public announcement of the new regulations. So let’s look at the quote from the interview with CFO Cong one more time.

Mr. Cong assured that CreditEase and Yirendai were “in full compliance” with the new requirements, and that the two companies were in “close discussions” with CBRC ahead of yesterday’s announcement.

PART J: Chairman Ning Tang “orders” employees to buy undisclosed US equities or be FIRED !

Imagine for a moment if there were a company which operated in the US, which employed US citizens. The company then sends out an order to all of the US employees, telling them that they must convert their own personal US dollars into Chinese RMB and then contribute their RMB into an investment vehicle controlled by the Chairman of the company. That vehicle would then take US employees’ money and buy some “unnamed” stock that only trades in China.

Sounds ludicrous right ?

Read on because according to posted leaked emails, this is exactly what YRD’s parent company appears to be doing with its Chines employees as it forces them to buy some “unnamed” US dollar stock. (The only US dollar equity that I can find tied to YRD’s chairman happens to be YRD.)

A few weeks ago, a financial news portal in China began publishing leaked internal emails between management and employees at Credit Ease. Credit Ease is YRD’s parent company and both entities are controlled by YRD Chairman Ning Tang.

What we find is an emailed employee complaint to Chairman Ning Tang as well as the emailed response from Chairman Tang to that employee.

The site posting the leaked emails is known as “Financial Gossip Girl” ( 金融八卦女)。Its web address is simply the Chinese Pinyin for that name (jinrongbaguanv.com), which now redirects you to download their App directly.

Financial Gossip Girl is a crowd sourced portal covering the financial services industry in China. The group currently employs a group of 10 editors with professional finance backgrounds, all of whom remain anonymous.

Much of the information on the site appears to be sourced from employees in some of China’s largest financial firms. It was first established as a website in 2011 by a group of finance professionals in China. So the site has now been around for 6 years.

In 2016, Financial Gossip Girl was featured in an article in Harper’s Bazaar China which gives more detail on the group. Other scattered reviews of the site can be found on Chinese financial sites.

The group has stated that the purpose of the App is to eventually become a full social networking site for finance professional, arguably similar to LinkedIn, but with the twist that users can post detailed information on their employers.

In the US, where financial services are much more heavily regulated than in China, we clearly do not have such a site covering the financial industry. But in the pharma industry we have something quite similar in the US.

The analogy I use is that of Café Pharma (cafepharma.com) , which is a website where pharma employees in the US can log on and share very detailed information about what goes on inside. I use Café Pharma often when researching US based pharma companies and it is often exceptionally informative about what really goes on behind the scenes at Big Pharma in the US.

(For those who are interested in following Financial Gossip Girl in China, it is the App that delivers the most news in the easiest to use form. It can be downloaded from Apple’s AppStore. While I am in Asia, the updates come in throughout the day. But in the US, you can expect multiple updates to your smartphone every day during the wee hours of the morning, which gets a bit annoying.)

Here is a complete pdf file of the email posting to and from various Credit Ease employees.

(Note: I have spent enough time in China that I am more than comfortable enough reading these Chinese documents. But for the sake of objectivity I hired a professional Chinese translation firm in Los Angeles that specializes in servicing Fortune 500 firms in legal disputes that involve Chinese.)

The title of the posting was as follows:

宜信强制员工买500美元的产品，不买就被辞退！还要附带50美元手续费

The translation of this reads:

Credit Ease forces employees to buy USD500 of “product” or be fired ! Also must pay a USD 50 service fee.

The “product” here is the asset management “product” being offered by Toumi, the asset management firm listed above (which YRD isn’t even supposed to be involved with under the new Chinese regulations).

The reason that Chinese employees (who are paid in Chinese RMB) are being forced to come up with USD to invest is that this “product” of Toumi is one in which the company buys US listed equities.

References in the email below to “RA” refer to Toumi’s “Robo Advisor” which takes the employees USD contributions and then selects the investments for them. The employees do not select their own investments.

Given that Ning Tang is only connected to one US listed stock, there is only one logical choice for which US listed equity he would be forcing his employees to buy under threat of being fired. For me, the only sensible conclusion is YRD.

This view is further bolstered by the information above which shows that an unnamed “Fund” affiliated with Ning Tang was buying up shares of YRD during the course of 2016, and then dumping those shares of YRD as soon the company ran into public regulatory problems.

But with the current Toumi purchases, the benefit to Ning Tang and his Fund would be that the money at risk here is coming from thousands of low level Credit Ease employees. It is no longer his money or the money of his affiliated Fund.

The employees are employed in two different Finance groups. There is Group #1 and Group #2. Both are required to make USD investments into the USD investment “product”.

The first disclosed email shows the following:

(click to enlarge)

The translation of this reads:

(click to enlarge)

It is important to note that the deadlines for making contributionsinto the asset management “product” come before employees are paid their year end bonuses. So even if an employee doesn’t think he will be fired, he knows that his full year bonus will be in jeopardy.

Following this mass email to finance department employees, one employee wrote directly to Chairman Ning Tang. That email is shown here (name redacted, finance department #1).

(click to enlarge)

He makes a clear reference to commands from Ning Tang that those who don’t contribute to the USD investment “product” should not come to work on Monday.

(click to enlarge)

Finally, we have the response from Ning Tang.

Chairman Tang’s response is very flowery and polite. It is full of encouragement.

But at the end, he makes it very clear that contributing to the Toumi USD investment “product” is mandatory for all employees. He makes no apology or correction of the statement that employees who do not contribute will be fired.

(click to enlarge)

(click to enlarge)

The language, the source and the level of detail above cause me to believe that the exchange above is authentic. I did send an email to Credit Ease asking about this issue but I have not yet received a response.

PART K: CONCLUSION

Without even looking at YRD specifically, investors should know that investing in ANY of China’s P2P players is just downright dumb. The industry has exploded in size due to poor oversight and regulation which is already resulting in massive and widespread fraud and defaults.

This is why China’s securities regulators have sought to protect Chinese investors from P2P IPO’s and forced the P2P players to simply IPO in the US.

It is also why precisely NONE of the traditional “smart money” in China, which is present in most Chinese ADR’s, has been willing to invest in YRD AT ANY PRICE. Outside US investment in YRD consists primarily of “quant funds” who plug YRD’s attractive headline metrics into their “factor models”. I believe that they simply don’t know what they own. Likewise, YRD management also wisely refuses to own shares of YRD.

When YRD began making loans in 2013, precisely 100% of these loans were to prime “A Grade” credits. But as we saw, YRD could not generate substantial volumes of loans in this market. And in fact, YRD could not even generate a profit from these “A Grade” loans.

So instead, YRD quickly transitioned to deep subprime “D Grade” loans where borrowers pay up to 40% APRs for short term loans. Such deep subprime loans quickly comprised more than 80% of new loans being made by YRD.

To turbo charge growth even further, YRD introduced “Fast Track” loans where these deep subprime borrowers could get approved for a loan within just 10 minutes with minimal credit checks or disclosure and with the entire process being conducted by smart phone. Much of the borrower disclosure simply relies upon “the honor system”.

The result was 100% predictable: loan volume exploded exponentially as these deep subprime borrowers lined up to borrow money for such discretionary luxuries as plastic surgery and expensive vacations. In the short term, YRD appears to be reaping substantial profits from charging fees on such loans.

The problem is that no one in their right mind wants to lend to this type of borrower. As a result, to entice Chinese retail to lend, YRD offers a guarantee of interest and principle. This guarantee is shown explicitly on the loan contract shown to lenders on YRD’s web page. It is also readily apparent by observing that lenders receive the same rate of interest regardless of whether their loans are being made to “A Grade” credits or to “D Grade” credits. The rate of interest received by lenders is quite clearly being determined by the guarantee from YRD and NOT by the underlying credit of the borrower.

But in 2016, Chinese regulators made clear that such guarantees were illegal.

YRD has clearly stated that it is in compliance and that its practices are not “guarantees”. But regardless of what cute terminology YRD chooses to use we can see clearly that YRD guarantees interest and principle. This is plainly evident from:

– The lending contract on YRD’s website

– Disclosure in YRD’s 20F

– The economics being offered to lenders

YRD has cherry picked several specific very short term metrics which lead investors to believe that charge off’s and defaults are not problematic. But the reality if observably quite different.

“A Grade” loans have a longer history therefore have more data. For these supposedly “highest quality” loans, the charge off rates have already skyrocketed from 2.4% to 9% over a 3 year period. And this is for the very best of the best loans.

“D Grade” loans are more recent and therefore have less historical data to analyze. But we can already see the that “D Grade” charge off have literally exploded over just a few months, quadrupling from 1.4% to 6.2% just during 2016. And again, this is just the earliest stages for these newer loans.

The fact is that YRD likely doesn’t even need to care about the soaring defaults behind the loans that it is guaranteeing. I see YRD as just a dumping ground for deep subprime loan exposure for YRD parent Credit Ease.

Fully 2/3 of YRD’s loans actually come straight via its parent Credit Ease. Credit Ease takes a risk free 6% origination fee off the top right at the very beginning and regardless of who the borrower is. Subsequent defaults are not their concern. It is YRD and its US shareholders who bear the risk of these soaring defaults and guarantee exposure. YRD discloses that its agreements with parent Credit Ease may be “less favorable” than it would get with unaffiliated 3rd parties.

This is why precisely NONE of the management at YRD is willing to hold shares in YRD. Many of these individuals at YRD also happen to work for parent Credit Ease. Even Chairman Ning Tang only owns shares of YRD indirectly, via his ownership of Credit Ease.

We have already seen that an unnamed Fund, “affiliated” with Chairman Ning Tang was supporting the stock with large undisclosed share purchases when the share price was faltering last year. These stock purchases remained undisclosed for more than 6 months, and were only disclosed AFTER the Fund had already dumped its shares. Coincidently, the dumping of shares occurred at just the same time as the announcement of the new P2P regulations in China, which deemed that the guarantees such as YRD’s were in fact illegal. (YRD appears to have known about these new regulations in advance.)

The Fund clearly was unwilling to bear the risk of attempting to support YRD’s share price. So a different method needed.

Most recently, we can now see leaked internal emails from Credit Ease which show an edict from Chairman Ning Tang, requiring Credit Ease employees to personally come up with US dollars to invest in an asset management “product” controlled by him (Toumi).

The required deadline to make such investments was December 31st, 2016 such that any effect from it is now well behind us.

The employee US dollars were used to invest in undisclosed US equities which are determined by Toumi, without involvement by the employees. The only US equity associated with Ning Tang is YRD.

According to the emails, employees who didn’t comply would be fired.

Given the information above, it is mind boggling to understand how any sensible investor would want to get long shares of YRD at ANY price.

Everything in this article represents solely the opinion of the author. Nothing herein comprises a recommendation to buy or sell any security. The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in YRD and during the past 12 months has shared his fundamental and/or technical views with other investors. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied

I first became aware of Live Ventures a few years ago when I was investigating and exposing an illegal stock promotion firm called The Dream Team Group. At the time, the company was known as Live Deal and one of the Dream Team promoters was moonlighting, also writing for another stock promotion firm. That firm was looking to recruit writers to write undisclosed paid promotions on Live Ventures.

My first article at the time exposed the Dream Team and their two primary promotions, Galena (NASDAQ:GALE) and CytRx (NASDAQ:CYTR). I then followed up with various other articles exposing many other related stock promotions. A few of them were stocks which I had shorted, but with many more of them, I highlighted their problems just for the sake of cleaning up the market, even though I had no financial interest.

As expected, nearly all of these promotions (once exposed) fell by at least 90%. Executives resigned. SEC investigations ensued. Shareholder lawsuits were filed. Some have been delisted outright and gone to zero.

As always, there had been volumes of supposed “analysis” of each of these companies’ business prospects. And, of course, in each case, the business appeared to be compelling. But as is always the case, whenever I find evidence of the individuals, promotion firms and tactics of stock promotions, these businesses ALWAYS end up failing. The purported business descriptions and developments are nothing more than manufactured fantasy. They are designed to sound great for the sole purpose of luring in retail investors. And then they fail.

In the end, there were still many other stocks which I had come across but which I never got around to writing about. In some cases, the stocks were too small and illiquid for anyone to care. In other cases, they traded for just a few pennies. And in some cases, I simply had too little information at the time to merit a full report.

But over time, some of these legacy stock promotions rear their heads again, so I do try to keep my eye on them. Live Ventures is one of those stocks.

As with the others, I will demonstrate clearly the view that Live Ventures is nothing more than a paid stock promotion with negligible business prospects. Investors have been grossly misled into bidding up the stock price by several hundred percent in just a few weeks. As investors see the true background facts, I expect the stock to quickly implode just like the others.

Preview of this report

There are so many blatant problems behind the promotion of Live Ventures that it is difficult to know where to start.

I will break this report down into the following Parts:

PART A – THE ONGOING PAID PROMOTIONS, INCLUDING THROUGH DECEMBER 2016.

Here I will show how millions of dollars have been paid to some of the most notorious stock promotion firms which happen to still be operating. Live Ventures is being promoted by the same firms I have exposed in the past and who were responsible for the promotion of stocks such as Forcefield Energy (NASDAQ:FNRG), among others. Following my exposure of Forcefield, the stock fell by 60% within days. The Chairman was promptly arrested by the FBI as he tried to flee the country. The stock was then halted and delisted, going to zero all within a few trading days.

I will show how these firms often interact with one another to obscure the nature of the ultimate paying party for the promotions. Buried deep in the disclosures, we can see that the promoters end up admitting to us that they are being paid to present deliberately skewed information for the sole purpose of making stock prices rise. The promoters have explicitly noted that stock prices typically rise sharply during their promotions campaigns, at which time they sell their own shares into the hype. Again, the information is hard to find, but in order to absolve themselves of liability, the promoters warn that most investors who invest during their campaigns will lose most or all of their money when the stock prices crash. Additional warnings (included below) should generate similar levels of concern. Wherever possible, I include the stock promotion firms involved as well as the dollar amounts they have been paid.

These promotions have been ongoing even through the month of December, even on the last day or two before the stock exploded to over $30. But now the paid promotions appear to have come to an end. The share price has been falling almost every day since earnings were released, even on light volume. Without a promotion in place, there simply aren’t buyers willing to support the stock.

Anyone who buys into the stock with this knowledge is deliberately signing up to lose money into the hands of professional stock promoters who know that the stock is about to collapse. Buying Live Ventures under such circumstances is literally downright idiotic.

In Part B I show how Michael Markowski became an aggressive “bull” on Live Ventures just beginning in November 2016, right as the simultaneous paid promotion began to take off and the stock price began to triple. Mr. Markowski has now written on Live Ventures 9 times in less than 6 weeks. He dramatically urges investors to buy “at market” – not using limit prices and “recommends” continued purchases even as the price went higher and higher. Mr. Markowski assures investors that Live Ventures will soar to as high as $180 (a 9 bagger from current levels) during 2017. Perhaps his perfect timing on getting involved with Live Ventures was pure coincidence. Or perhaps not.

Many of the statements included in Markowski’s articles are flat out wrong. Yet investors have relied upon this inaccurate information to buy shares of Live Ventures at ever higher prices. Details on these inaccurate statements are provided below.

Mr. Markowski regularly touts his deep and lengthy expertise in the securities industry acquired over 40 years in the business. But he blatantly fails to disclose that the SEC charged him with a host of securities fraud violations which it described as being so “egregious” that barring him from the industry was “in the public interest”.

The SEC noted that

Markowski’s conduct was egregious. The complaint in the injunctive action describes the manner in which Markowski knowingly and recklessly manipulated the market prices of three Global-backed securities, including aggressive and fraudulent sales practices, unlawful solicitation of aftermarket orders during initial public offerings, and delayed execution of the sell orders of Global customers.

In other words, Markowski would use fraudulent means to induce customers to buy securities at manipulated prices and then his brokerage would prevent them from executing their sell orders (sometimes for months) even as the stocks plunged.

This is eerily similar to the content of his recent articles in which he keeps urging investors to buy “at market” and then to buy more even after the stock tripled. Investors are strongly urged to never sell.

The vast, vast majority of individuals in the securities industry will never have any sort of violation on in their history whatsoever. When the very rare person does, they will be penalized. A bar from the industry is a truly rare occurrence reserved for the worst of the worst violators in the business where the SEC feels it needs to protect investors from their further behavior.

PART C – THE INACCURATE “PROMOTION FODDER”

All promotions need some sort of talking points to get investors excited. These can often be acquisitions or other corporate events. The “fodder” is then echoed and amplified by the company in its press releases and then further hyped and promoted by stock promoters.

Live Ventures has put out multiple press releases touting tremendous new developments. In fact, we can see that the information that is touted in their press releases does not match what the company has disclosed to the SEC.

Live Ventures states that Isaac Capital Group (which is solely controlled by Live Ventures’ CEO Jon Isaac) has locked up “ALL” of its shares for 5 years, implying that the CEO cannot sell his shares.

Yet in addition to the 800,000 shares which have supposedly been locked up, Isaac has access to around 700,000 additional shares via warrants / options which have average exercise prices as low as $4.14 and which expire in less than 2 years. THE WARRANTS ARE EXCERCISEABLE IMMEDIATELY – meaning that Isaac can exercise and sell over $10 million of stock any time he wants.

Live Ventures put out a press release claiming that the company achieved EPS of $8.92 in 2016. This is WRONG and is inconsistent with Live Ventures’ SEC filings.

First off, the $8.92 which was touted in Live Venture’s press release was calculated by subtracted the 800,000 shares which Isaac agreed to lock up. This is wrong. Even in its own SEC 10K filing, Live is not able to calculate EPS this way. The number as shown in the 10K is actually $5.40. So Live Ventures has already overstated its EPS in the press release by 65%.

In fact, anyone running a text search on the 10K for the number “$8.92” will find no hits at all.

But then it gets better. Live Ventures didn’t even realize a true profit at all. Live Ventures LOST MONEY. The GAAP Net Income number provided the company was $17.8 million. But to achieve this, the company added in almost $19 million of arbitrary one time accounting adjustments, some of which appear to have no precedent in public company accounting. So in fact, Live Ventures did not post a true profit at all – instead, Live Ventures actually lost nearly $2 million.

These one time arbitrary adjustments (made at the company’s own discretion), are broken down in detail below.

Our barred “bull” Markowski has tried to spin these bizarre adjustments as a positive for Live Ventures. He has also specifically assured us that

Before conducting any additional analysis, I checked out its auditor. I discovered that it was Anton Chia, which is one of the most respected and SEC approved auditing firms.”

In fact, Anton & Chia is not even a top 50 audit firm. It was just cited (in September 2016) by the PCAOB for multiple egregious audit deficiencies, including failure to conduct proper audits in accordance with GAAP (which is exactly what I see at Live Ventures). The firm’s client list has heavy inclusion of imploded China/Asia reveres merger bulletin board stocks which trade for just pennies. Some no longer trade at all and have failed to file with the SEC. And oh, by the way, the SEC does not “approve” audit firms at all. Ever. That is not what they do. So once again, the information Markowski uses in urging investors to place “market orders” is egregiously wrong. The information on Anton & Chia is publicly available and easy to find with just a 5 minute Google search.

In November, Live Ventures announced an acquisition of “Vintage Stock” which it touted was going to bring in massive revenues to the company and involve no dilution. Given the two press releases above, investors have every right to be skeptical. Within weeks, the company was already making large downward revisions in its projections.

Until we see a detailed 8K for the acquisition, we have no idea what to expect from this acquisition. (Although I do provide more detail on Vintage below).

PART A – THE “USUAL SUSPECTS” AND WHAT THEY ARE HIDING

Live Ventures’ stock has shown a repeated pattern over time. When the stock trades at a very low price, a reverse split occurs to raise the price up and reduce the float. At the same time, some new acquisition or corporate development is announced. Simultaneous paid promotions (which have now run into the millions of dollars) help to temporarily drive the stock up. But when the business fails to produce results, the stock price falls again and the process is repeated.

The most recent promotion campaign saw the stock triple in November to December 2016.

As in the past, there was a reverse split which coincided with some sort of “news”. As in the past, there is the presence of heavily compensated stock promoters. And as in the past, the stock price quickly showed a reaction, tripling in a few weeks.

Over time, stock promoters are getting more sophisticated. In the past, their hyped-up promo material would sit out in cyberspace for extended periods of time, even after the promotions ended. This would simply provide ammunition for people like me to discredit the promotions as the stock prices began their inevitable implosions.

But now the promoters have often wised up. Their promotions usually go up on specialty sites designed just for the promotion. The promotion material is then removed once the stock price soars. After all, once the stock price rises and they dump their stock, there is no ongoing benefit to maintaining a permanent record of the promotion.

In other cases, stock promoters use huge email blasts to millions of retail investors. Because they do not appear on web sites, the information behind these promotions is usually untraceable.

Fortunately, there are some of us out there who sign up for as many promo emails and sites as possible and then store all of the emails.

And also in some rare cases we can still track down the occasional promotion that has not yet been deleted, such as the one below. (I have saved pdf copies of this because I expect the material to be deleted).

This one (“Stock Market Leader”) comes from the promotion last dated December 27th, 2016. So just a few days ago. Note that this is just before the stock soared and that the promoter was paid $15,000.

Here are screenshots of a few of the emails that came out in December and which there are no longer any records of:

So now we can see that in just a few weeks in December, around $100,000 has been spent on pumping up the stock by promoters who know that the stock is going to decrease when the short term campaign ends.

And again, so far this is just what I have been able to find. There is likely much more out there that has already disappeared.

Ultimate Stock Alerts, ProTrader Elite and Goldman Small Cap Research

Shown above are promotions from Ultimate Stock Alerts and a variety of affiliated stock promotion firms tied to Pro Trader Elite LLC. Live Ventures (and formerly Live Deal) have also been frequent promotions tied to “Goldman Small Cap Research”. GSCR is a “paid for” research firm which touts microcaps and which has no connection to Goldman Sachs. People pay Goldman to write favorable reports. That’s GSCR does.

I highlighted both Ultimate Stock Alerts and Goldman Small Cap in this exposé on the promotion behind fraudulent Forcefield Energy. Both Ultimate and Goldman were paid to promote Forcefield. Following my article, the stock was quickly delisted and went to zero. The Chairman and 8 others were imprisoned following their indictment in this $100 million fraud.

We can also see that these promoters use a maze of paying parties to obscure who is really behind the promotion. Many times, seemingly independent promotions all tie back to ProTrader Elite, which then uses a variety of different names.

My favorite is “Small Cap Firm“. Small Cap Firm gets paid by ProTrader Elite to sub-run additional promotions using the same information.

It took me days of digging to find this, but ultimately I was able to find an “orphan” page which does not appear to be linked to anything else, which describes how the promotions work and how they will affect investors. Click here to read the whole thing. But here are a few examples.

Again, these all tie back to firms (such as ProTrader Elite) which work together along with the firms who are currently receiving millions of dollars in order to promote Live Ventures.

What will happen to the shares that we hold during the Campaign?

We will sell the shares we hold while we tell investors to purchase during the Campaign.

What will happen when the Campaign ends?

Most, if not all, of the Profiled Issuers are penny stocks that are illiquid (they do not have much trading volume at all) and whose securities are subject to wide fluctuations in trading price and volume. During the Campaign the trading volume and price of the securities of each Profile Issuer will likely increase significantly. When the Campaign ends, the volume and price of the Profiled Issuer will likely decrease dramatically. As a result, investors who purchase during the Campaign and hold shares of the Profiled Issuer when the Campaign ends will probably lose most, if not all, of their investment.

Why do we publish only favorable Information?

We only publish favorable information because we are compensated to publish only favorable information.

Is the Information complete, accurate, truthful or reliable?

No. The Information is a snapshot that provides only positive information about the Profiled Issuers. The Information consists of only positive content. We do not and will not publish any negative informationabout the Profiled Issuers; accordingly, investors should consider the Information to be one-sided and NOT balanced, complete, accurate, truthful or reliable.

What will happen if an investor relies on the Information?

If an investor relies on the Information in making an investment decision it is highly probable that the investor will lose most, if not all, of his or her investment. Investors should not rely on the Information to make an investment decision.

So just how extensive has the promotion campaign been ? There is one locationout there which has archived just a few of the promotion emails out there. That site does not even have the most recent mailers (which I already showed above) and it does not track to the websites such as “Stock Market Leader” (which I also showed above).

We can see that a large variety of seemingly “independent” stock promotion firms have now been paid millions of dollars to run this type of campaign on Live Ventures. As shown above, the information is only positive and consists of pure hype to drive the share price up.

In the past, one promoter, was actually paid a whopping $1 million to run a short term promotion campaign on LIVE.

Here are just a few of the many titles used in various email campaigns.

Prior to the recent 1:6 reverse split, a firm by the name ofMarket Bytegave us the following:

So that implies a target price of $30-42 now that we are past the reverse split. Market Byte waspaid $15,000for this.

I want everyone to take a look at it TODAY and keep **LIVE** on your Radar for the LONG TERM!! I will be back to talk about “LIVE” at another date in time…. Hopefully it will be one this Play has already produced some INSANE Gains from it’s current low!

Again, there are well over 100 examples of such promotions on Live, with paid amounts varying from a few thousand dollars to as high as $1 million.

And again, these are just the ones we can track down. Many more have likely been removed from circulation and can no longer be found.

Here are the 9 articles that Markowski has written over just the course of 6 weeks.

Before getting into the specifics on Michael Markowski, readers should take a step back and get some perspective on these recent articles. As I will show, these articles deserve a high level of scrutiny REGARDLESS of who wrote them.

First, the timing is noteworthy. The author’s articles on LIVE never appeared until a massive simultaneous paid promotion was being launched on Live Ventures, including payments of hundreds of thousands of dollars to paid stock promoters. As in past promotions, this surge in promotional activity coincided with a reverse split along with multiple apparent corporate developments. Yet these developments alone had no impact on the stock, instead it was the promotions that boosted the stock. And these articles only appeared at the exact same time as the promotions.

Second, the sheer number of articles deserves attention. In the space of just 6 weeks, the author released an urgent flurry of 9 articles.

Third, the urgency and hyperbole behind the articles is unusual. The author urges readers to “buy at market” and not use limit prices, even as the stock was hitting new 52 week highs. To recommend retail investors place “market” orders on a low float small cap stock is downright irresponsible. Even relatively small orders could create large price surges, resulting in terrible execution prices for investors. Even as the price continued to rise, the author continues to urge “market” orders at higher and higher prices and then continues to raise his price target. Investors are explicitly told (in ALL CAPS) to NOT SELL shares, even as they hit a new high. (The next day the shares fell by almost 30%.)

Fourth, the blatant errors, inaccuracies and omissions deserve special attention. A few of these are included below.

Again, the point I am trying to make is that when we see this combination of problems, we should immediately start to be highly concerned about the author and his content.

But this content didn’t come from just any author. It came from Michael Markowski. That makes the problem visibly much bigger.

Markowski frequently touts his “prestigious” background in the stock market with quotes such as:

Entered capital markets upon graduation from college in 1977. Broker, IPO banker, analyst and futures trader during career

What Mr. Markowski fails to include in this “prestigious” biography is that he was expelled from the securities industry for committing extensive securities fraud and then barred by the SEC from future activities.

This was not a “minor” securities fraud case.

Instead, the SEC explicitly described the conduct of Markowski as “egregious” and noted that

Markowski’s conduct with respect to market manipulation and customer complaints regarding unexecuted sell orders demonstrates a high degree of scienter.

Scienter is a legal term that refers to intent or knowledge of wrongdoing. This means that an offending party has knowledge of the “wrongness” of an act or event prior to committing it.

According to the SEC, below is what Markowski did. Readers can note for themselves the eerie similarities to his current articles on Live Ventures.

Markowski “conducted aggressive and fraudulent sales campaigns to promote the securities, which included making specific price predictions about the securities”

Markowski then “instructed Global brokers to solicit unlawfully aftermarket orders during the distribution of the units.”

Markowski then “restricted the supply of these securities by discouraging brokers from accepting customer sell orders, reprimanding brokers who did accept sell orders, paying brokers commissions on buy orders but not sell orders, and fraudulently delaying the execution of customer sell orders for days, weeks, or even months.

The SEC notes that these problems were brought to the attention of Markowski by the firm’s compliance officer, but he still did nothing. Markowski came up with numerous excuses for the behavior, including blaming the problems on a fire which damaged the firm’s telephone systems. (Unfortunately, the SEC shows that the problems began well before that fire even occurred.)

The violations above occurred with at least 3 different stocks. But these violations themselves were not isolated.

The SEC then noted that:

Markowski also has a disciplinary history. He failed to provide the NASD with access to Global’s books and records in the initial stages of the NASD’s investigation of the same market manipulation at issue here. This is a serious violation of the NASD’s Rules of Fair Practice for which Markowski was censured, fined $50,000, and given a two-year suspension in all capacities and a permanent bar from acting as a principal or having any financial interest in any NASD member firm.

As I see it, Mr. Markowski has acted in a similar fashion with Live Ventures. He seeks to drive up the price in the same way, by inciting “market orders” in a small cap, low float stock. He continues to urge additional buying even as the share price soars, continually raising his target price, using specific prices as he did in the fraudulent conduct above. He then seeks to dissuade investors from selling even as the share price begins to fall apart.

The SEC also noted that following his involvement the 3 stocks above, the share prices all collapsed.

Here is a brief list of just a few of the inaccurate statements made by Mr. Markowski in his articles:

1. For Live, he stated that “Before conducting any additional analysis, I checked out its auditor. I discovered that it was Anton Chia, which is one of the most respected and SEC approved auditing firms.” As shown in the next section. Anton & Chia was cited in September 2016 for multiple egregious audit deficiencies, its clients list largely consists of imploded reverse mergers for China/Asia OTC stocks, many of which either trade for just pennies or no longer report or trade.

2. He also stated that LIVE had positive Free Cash Flow of positive $2.0 million in Q4 2016. This is provably wrong. In fact, Live Ventures had a Free Cash Flow of NEGATIVE $2.5 million. As a self described “cash flow expert”, Mr. Markowski should certainly be familiar with the standard definition of FCF: “Free cash flow (NYSE:FCF) is a measure of a company’s financial performance, calculated as operating cash flow minus capital expenditures.” It is actually very simple and well defined. Yet for some reason, Mr. Markowski decided to add $3.3 million back for prepaid expenses. This is simply an arbitrary adjustment made by Mr. Markowski to arrive at a positive number.

3. On December 20th, Markowski stated that Live Ventures has an extremely rare “Free Cash 50% yield”. As of that date, Live Ventures was already trading at $20, which would mean that Live Ventures was generating Free Cash Flow of $10 per share, or $28 million. Even using the exaggerated numbers provided above does not come anywhere near $28 million in FCF in 2016. And then it gets even better. Markowski states that: “Due to LIVE having an extremely rare Free Cash 50% Yield anomaly its share price will go to a minimum of $50.00 in 2017 regardless of how the S&P 500 performs.”

4. Stock “bulls” commonly try to blame short sellers when a stock price implodes. They try to use this to convince retail buyers to buy the stock. Markowski stated that “Based on 2.2 million shares trading on December 28th, the probability is high that short sales accounted for a significant percentage of the volume.” In fact, we can see the amount of short interest over time at NASDAQ.COM. Over the past 4 months, total short interest has ranged from 70,000-90,000, so nothing near the millions of shares that Markowski implies. From the site iBorrowDesk, we can see that total additional shares available to be shorted has seldom been more than 25,000 on any given day. And before he tries to blame the “naked shorting” bogeyman (another favorite excuse and distraction for stock “bulls”), we can see that the SEC also tracks the total amount of shares being shorted “naked”. It is called their “fail to deliver list”.For Live Ventures, the most recent number of “failed to deliver” (i.e. naked shorted) shares amounted to just 4,054 shares (yes, just four thousand shares). The reality is that short sales have accounted for virtually none of the volume. Anyone who claims 40 years in the industry should be able to find this information in just a few minutes.

5. Markowski states that “CEO Jon Isaac owns 1.1 million shares”. As shown below, Isaac controls over 1.5 million shares, nearly half of which are available for immediate sale via warrant exercise. That is a difference of nearly $10 million into the CEO’s pocket and is directly relevant when we are looking at stock promotions.

Beyond the inaccuracies we can see multiple statements which are deeply reckless in his explicit buy “recommendations”.

2. He also urges investors to place “Good Til Cancled Limit Orders” to buy at a price of $26.25 (even as the share price was plunging to $22). The effect of this would obviously be to support the share price.

3. He makes statements such as: “Due to LIVE having an extremely rare Free Cash 50% Yield anomaly its share price will go to a minimum of $50.00 in 2017 regardless of how the S&P 500 performs.”

4. Assuming that LIVE’s outstanding shares remain at 2.8 million the minimum price for its shares by the end of 2017 could potentially range from $45 to $180.00.

5. “LIVE’s shares are being shorted instead of being aggressively purchased. Its because should an investor or conduct a preliminary analysis and not dig much deeper the tendancy is to short instead of buying LIVE shares. Upon investors becoming aware of this anomaly the share price will go to above $100. This report will enable you to fully grasp the significance of the anomaly and why a short squeeze is inevitable.” As shown above, anyone with even a few years of experience in the market would know that this information is provably false with just a few minutes of looking.

For reference, here is the most recent short interest data from NASDAQ.COM. It shows that short interest in Live Ventures has consistently been negligible. Mr. Markowski would know that with just a single Google search of “LIVE Short Interest”.

PART C – DEBUNKING THE PROMOTION FODDER

In every promotion campaign, it is necessary to have some talking points for the promoters to sell to retail investors. This is what I refer to as the “promotion fodder”.

As will be shown in greater detail further below, each of these items has been overly hyped or misrepresented outright in promoting the stock.

In fact, even the press releases put out by Live Ventures itself contain information that does not match its SEC filings. Not surprisingly, the erroneous information is heavily to the advantage of the share price.

In December, Isaac Capital Group, our largest stockholder, agreed to lock up ALL of their shares for five years (through December 31, 2021)… Accordingly, our common stock was reduced from approximately 2.8 million to 2.0 million shares.

Isaac Capital Group is controlled by Live Venture’s CEO Jon Isaac. He is the largest shareholder.

The message here is clear. The CEO cannot sell any of his shares until 2021. Clearly this is a strong vote of confidence in the stock, and it has helped support the share price.

But that assumption is wrong. The following information can be found in thefootnotes(part F-19) of the 10K.

If we look at warrants / options held by Jon Isaac and/or his Isaac Capital Group, we can see that he has control of more than 1.5 million underlying shares in total. This includes almost 590,000 shares underlying his warrants. These warrants have an average exercise price of just $4.14 and they actual EXPIRE in less than 2 years. THE WARRANTS ARE EXCERCISEABLE IMMEDIATELY.

So here is the kicker, by appearing to lock up “ALL” of his common stock, the CEO supports the share price. He therefore can get a much higher price when he sells nearly 700,000 other shares that no one seems to have noticed. Even if the original shares go to zero in 5 years, the CEO would stand to make more than $10 million if sold at current prices. Without giving the “appearance” of a lockup, this would not otherwise be possible for the CEO.

And again, the warrants can be exercised for just $4.14, they are exercisable immediately and they EXPIRE in less than 2 years. The “lockup” is nonsense.

But it gets even better. In order to effect this apparent “lockup”, the CEO “converted” his 800,000 shares of common stock into basically identical preferred shares. As a result, when Live Ventures announced their EPS for 2016, they divided their “earnings” by 2 million shares rather than 2.8 million shares. This is how the company seemingly reported an EPS of $8.92.

But that $8.92 was ONLY announced in the flashy press release. It was not included in the SEC filed 10K. (Feel free to run a text search through the 10K for yourself). In the actual SEC filings, we can see that Live Ventures was forced to report the actual EPS number of $5.40.

And as we see next, even that $5.40 was EPS was only the result of one-time GAAP earnings manipulation. Without that manipulation, the company actually would have reported a NET LOSS, NOT ANY NET INCOME AT ALL.

(We will look more closely at problems with Live Venture’s PCAOB deficient auditor below.)

Fodder #2: The supposed surge in “earnings”

The tremendous promotion surrounding Live Ventures appears to have really kicked off right around the time when Q4 earnings were announced on November 21st, 2016.

At that time, the company telegraphed that it expected “record” year-end financials would be announced in December. Many promoters as well as “bulls”, including Markowski, began amplifying these expectations and urging investors to aggressively purchase the shares.

Live Ventures certainly did not disappoint (well, at least not on the surface). On December 29th, the company announced (in a press release only) that it had reported “record” earnings of $8.92 per share.

Hype around the upcoming earnings caused the share price to briefly spike by as much as 40%, from $23 to $32. But once the 10K was released and read, the stock quickly gave up all of these gains.

As already shown above, the $8.92 number is clearly wrong. It was only achieved by using a too-small share count which was not included in the actual SEC filings. The SEC filed 10K shows EPS of $5.40.

But even that $5.40 number is not an accurate representation.

Live Ventures reported total Net Income of $17.8 million for 2016. This number is WRONG.

In the press release, the company then dividend this $17.8 million by 2 million shares outstanding to report EPS of $8.92 in the press release. As shown above, this number is also WRONG.

In calculating the $17.8 million in Net Income, Live Ventures added in multiple one time arbitrary items which it added at its own discretion. These were not the result of any ongoing business.

This included the following:

Item

Amount

Bargain purchase gain on acquisition

$4.6 million

Change in deferred tax expense

$12.5 million

Vendor and note settlements

$1.7 million

Gain on asset sales

$179,000

TOTAL

$18.98 million

As you can see from the names of the line items above, each of these items are non-operating items which have nothing to do with the ongoing business of Live Ventures. Together, these items count for more than 100% of the supposed “profit” reported by the company.

The bulk of these items were added at the discretion of management in a way that is simply arbitrary. They simply added them because they wanted to.

The reality is that without the benefit of these arbitrary accounting manipulations, Live Ventures didn’t show any profit at all. Instead, Live Ventures actually LOST around $1.5 million instead of EARNING over $17 million.

So the question becomes: how does Live Ventures auditor allow the company to get away with such egregious behavior ?

After earnings were released (and as the stock was quickly falling), stock promoter Markowski assured investors that arbitrary items such as “Bargain purchase gain on acquisition” were actually a strong positive for the company. He states that:

It’s pure and simple, LIVE’s earnings increased by $4.5 million due to the company being extremely conservative in valuing and negotiating an acquisition. It is what it is!

Markowski noted that:

I had never in my 40 years seen the booking of such an entry on a company’s Financial Statements….Before conducting any additional analysis, I checked out its auditor. I discovered that it was Anton Chia, which is one of the most respected and SEC approved auditing firms.

I agree with Markowski in that “bargain purchase gain on acquisition” is a very rare item. I have been deeply involved in the stock market since the late 1990’s and I have never seen it either. It is basically a made up item used to arbitrarily boost the company’s earnings.

As for the audit firm of Anton Chia, Markowski’s statements are flat out WRONG. That firm is neither the “most respected” nor “SEC approved”.

Anton Chia is not a big 4 auditor. It is not a top 10 auditor. In fact, it is so obscure that I can’t find any mention of it in the top 50 auditors. But we’ll let that slide for now.

First off, the SEC does not “approve” auditors. So that statement is flat out WRONG.

Second, in September 2016 (yes, very recently), the PCAOB disclosed egregious deficiencies in the audit practice of Anton & Chia. Their report is publicly available and easy to find.

To read all of the deficiencies noted, simply read the report. In the very beginning of its report on Anton & Chia, the PCAOB noted that:

Certain deficiencies identified were of such significance that it appeared to the inspection team that the Firm, at the time it issued its audit report, had not obtained sufficient appropriate audit evidence to support its opinion that the financial statements were presented fairly…In other words, in these audits, the auditor issued an opinion without satisfying its fundamental obligation to obtain reasonable assurance about whether the financial statements were free of material misstatement.

All told, the PCAOB cited 11 such material deficiencies, several of which appear to be strikingly similar to the accounting shenanigans that we see at Live Ventures.

Examples from the PCAOB deficiency report (published September 2016) include the following:

Does this sound familiar ?

the Firm’s failure to identify, or to address appropriately, a departure from GAAP that appeared to the inspection team to be material, which related to the improper valuation of a recorded impairment loss

Does this sound familiar ?

the failure to perform sufficient procedures to test a business combination

Does this sound familiar ?

the failure to perform sufficient procedures to test the occurrence and valuation of revenue, including the inadequate performance of substantive analytical procedures

Many audit deficiencies involve a lack of due professional care.

Anton Chia does not disclose its client list on its website. The only lists I can find are on the site “Auditor Carousel” which highlights auditor changes typically due to the implosion of the auditor or due to auditor shopping by microcap companies.

Here are the companies named as RECENT (2016) past or current clients of Anton Chia

Company

Ticker

Share price

Market Cap

China Longyi

CGYG

$0.03

$2 million

Thunder Energies

TNRG

$0.23

$3 million

EverythingAmped

N/A

No longer quoted

N/A

Next Group

NXGH

$0.02

$6 million

Malaysia Pro-Guardians

MPGS

$0.02

$2 million

QMIS Finance

QMIS

$2.50

$14 million

Borneo Industrial

BOFC

$0.00

Zero

Max Sound

MAXD

$0.01

$10 million

Vortronnix

N/A

None (failed to file)

N/A

So it is hard to see how Markowski comes up with Anton Chia as being among the “most respected” auditors. In fact, I view having an auditor like Anton Chia as being more of an embarrassment than a mark of honor.

In any event, to me, the use of Anton Chia helps to explain how a $1.5 million dollar net loss was magically transformed into an accounting profit of almost $18 million without any underlying business activity to support it.

Fodder #3: The acquisition of Vintage (AKA the next Blockbuster and the next Borders Books)

On November 7th, Live Ventures announced the acquisition of Vintage Stock, a retailer which buys and sells things like used movies (including VHS), music CD’s and video games. The cost of the acquisition was $60 million and was done via bank financing (i.e. no stock was issued).

At the time of the acquisition, the stock barely budged. On the day before the acquisition, the stock sat at $10.98. On the day the acquisition was announced, the stock hit $11.52, up a few percent. On the next day, the stock was flat. No one cared.

The reason for the lack of enthusiasm is that trading music CDs and old video games in retail stores is not a growth business anymore. Much of this is now simply done online. Videos, music and games can simply be downloaded without visiting a store. If I want to buy a physical copy, I do so via Amazon for a fraction of the price.

Vintage continues to engage in activities such as movie and video game rentals, just like the now bankrupt Blockbuster. In fact, Vintage actually acquired many of its Dallas area stores directly from Blockbuster and brags that it now offers “over a million titles to choose from in Movies, Music and Video Games.”

Following the going-out-of-business of its local competitor Hastings, Vintage simply moved in to that location in Kerryville, TX. Vintage hopes it will do better than its bankrupt predecessor

Vintage also bought a few locations of Borders Books as that company too was going bankrupt. Vintage has stated that it follows an 80-20 rule, where the 20% consists of selling books and magazines, just like the bankrupt Borders used to do.

Vintage also engages in the odd niche business of repairing scratched music CDs, for those out there who still use music CDs.

Vintage even continues to carry game cartridges for vintage consoles such as Atari and the old Nintendo, which were popular in the 1980’s.

There was no detailed 8K released with legacy or pro forma financials, such that we don’t really know what Live Ventures purchased here. But we do know that Vintage has 40 locations spanning 5 states, with 900 employees, such that getting $60 million in bank financing should not have been difficult for the company. Vintage could have certainly borrowed that much money itself.

For example, if Vintage owns $60 million of real estate, the Live Ventures could have just paid $60 million in exchange for $60 million in real estate, with the business itself being largely worthless.

But as we have seen, stock promoters needed some fodder for their promotions. And even though Live Ventures was clearly stepping into the shoes of several bankrupt predecessors, the promoters were able to spin it for a few weeks.

The website for Vintage describes its inventory of videos, music and games as being “massive”. So a second theory is that the “value” here was simply that of over valued obsolete inventory. After all, what are rental DVD’s worth today now that everyone can simply stream from Netflix, Hulu or Amazon for just a few dollars without ever leaving their home. If Live Ventures is valuing these rental videos “at cost” of $20 or more, then a $60 million valuation could be easily justified. But obviously older titles of used rental videos now have a value which is almost nil.

Because there has been no detailed 8K filed, we simply have no idea.

But just as with the other items of fodder, the promoters have been quick to predict multi bagger share price increases based on the minuscule amount of vague and unsubstantiated information released by Live Ventures.

(Note: Here is an example of a typical 8K that virtually all companies put out upon completion of an acquisition. It contains all of the relevant historical and pro forma financial information along with the detailed terms of the transaction and financing.)

It is notable that at the time Live Ventures announced the deal in November, that annual sales were immediately expected to increase to $160 million. But just a few weeks later, this number was already quickly being reduced to $120 million. They had therefore been overstated by 33%. No explanation for the steep revision was given.

The point is this. Live Ventures completed this acquisition in November and immediately put out a press release touting several unsubstantiated forecasts. Live Ventures never put out an SEC filed 8K with any concrete details. As we have seen in the past, there have been substantial discrepancies between Live Ventures press releases and its SEC filings. We literally have no idea what Live Ventures has purchased here because nothing has been disclosed. The company is already backing away from its initial vague rosy statements.

But so far the promoters behind Live Ventures have been quick to seize on the acquisition as further proof that the stock is going to catapult upwards by several hundred percent in 2017.

Even a casual analysis of Vintage reveals that the company is in various dying businesses including DVD and VHS rentals, CD music exchange and CD/DVD scratch repair. Vintage has repeatedly been buying out the locations of other dying businesses such as Blockbuster, Borders and Hastings, all of which went bankrupt / out of business.

EMAIL AND RESPONSE FROM LIVE VENTURES

All of the commentary above has been supported with links to external sources, including the company’s own SEC filings.

I have demonstrated clearly that CEO Jon Isaac has an extra 700,000 shares which are available through warrants / options, most of which are exercisable immediately. This information can be found clearly in the 10K.

In the commentary above I also showed very clearly “what was the impact of the EPS add backs and how they were calculated”. The answer is the earnings went from $17 million to a loss of around $1.5 million. I broke down what each component was.

I also showed that the number $8.92 for EPS was included in a press release, but this is significantly different than what is in the 10K filed just 1 day later.

I did send an email to Live Ventures’ IR email address. Rather than paraphrase anything, I have included here a screenshot of the response. (Responses from Live Ventures are in blue.)

I suggest that readers read the response below and then re-read the commentary above, clicking on the links to the various filings.

I note that in the responses below, in 4 out of 5 items, the response clearly did not actually answer the question that I asked.

For question number 4 (which was answered), the company has stated that they have 71 days to file an 8K for the acquisition. This should be interesting given that the CFO was just hired yesterday.

Conclusion

Live Ventures is a stock promotion which has been aggressively pumped by some of the most notorious stock touts in the business. These promoters have been paid millions of dollars to present skewed information on Live Ventures. Buried in their disclosures is the fact that they expect the stock to rise sharply on their promotion and to then plunge when it ends. They warn that anyone who buys into the stock should expect to lose “most or all of their investment”. These are the same stock promoters who have blatantly promoted frauds such as Forcefield Energy, which was delisted and went to zero within just a few days of my report on that company.

The most recent stock “bull” to get behind Live Ventures is Michael Markowski. Markowski began writing about Live Ventures just as the paid promotion was picking up steam and he quickly put out 9 articles in just 6 weeks. He has aggressively urged readers to put in “at market” buy orders, driving up the stock. He analysis contains numerous statements which can be proven totally false with just a few minutes of checking. Markowski was barred for life by the SEC following multiple instances of stock fraud which the SEC described as “egregious”. The bar on Markowski was deemed by the SEC to be in the public interest.

The ample promotion fodder on Live Ventures is easily debunked.

The supposed “lockup” of shares held by the CEO ignores around 700,000 shares which can be sold via exercising deep in the money warrants and options. These options are exercisable immediately and expire in less than 2 years.

The tremendous surge in “earnings” from Live Ventures was simply the result of accounting manipulation, including where Live Ventures “wrote up” the assets in acquired in the past. It made these various adjustments at its sole discretion, and thus transformed a $1.5 million loss into a $17 million accounting “profit”. As shown, Live Ventures uses a penny stock auditor known for auditing imploded China/Asia OTCBB stocks. This same auditor was cited by the PCAOB in 2016 for numerous and egregious audit deficiencies, including ones which bear striking similarity to the adjustments seen at Live Ventures.

The recent acquisition of Vintage Stock is effectively the equivalent of buying Blockbuster Video and Borders Books, both of which went bankrupt due to the transition to online viewing and downloading. Even a cursory view of Vintage’s website reveals that it still deals heavily I things like VHS cassette tapes and cartridges for 20 year old gaming consoles. The acquisition simply made for more talking point fodder for the stock promoters.

The promotion on Live Ventures has clearly come to an end. That is why the stock has been falling each day and why volume has been declining.

As the stock promoters clearly warned us:

What will happen when the Campaign ends?

Most, if not all, of the Profiled Issuers are penny stocks that are illiquid (they do not have much trading volume at all) and whose securities are subject to wide fluctuations in trading price and volume. During the Campaign the trading volume and price of the securities of each Profile Issuer will likely increase significantly. When the Campaign ends, the volume and price of the Profiled Issuer will likely decrease dramatically. As a result, investors who purchase during the Campaign and hold shares of the Profiled Issuer when the Campaign ends will probably lose most, if not all, of their investment.

Disclosure: Everything in this article represents solely the opinion of the author. Nothing herein comprises a recommendation to buy or sell any security. The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in LIVE and during the past 12 months has shared his fundamental and/or technical views with other investors. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied

Clear accounting manipulation by 26% demonstrated in recent quarters, Orthofix is currently grossly overvalued as a high growth player with a strong “moat”. (WRONG !).

Following the FDA move, expect Orthofix quickly to fall by at least 50% (share price of around $15-17).

Note: Everything in this article represents solely the opinion of the author. Nothing herein comprises a recommendation to buy or sell any security. Information in this post has been sourced from a variety of online sources, including current and historical documents from the FDA, the Federal Register, and the SEC, among others. Various links to relevant data and information have been included. Additional information has been provided directly via phone calls to the FDA’s Department of Orthopedics. Additional information may be available from these and other sources. As always, readers should conduct their own research and form their own opinions and conclusions.

Overview

I have been heavily focused on FDA issues with healthcare stocks for almost 20 years. My past articles highlighting problems with numerous healthcare stocks have quickly presaged share price declines well in excess of 50%, sometimes within just days. A few of these articles are shown below. The key theme in all of them is that most investors simply don’t do their research. (This includes institutions as well as individuals.)

Every once in a blue moon, I come across what I describe as a “unicorn short”. This is a short trade where there is massive near term potential downside, but with very little upside potential. It is a truly “asymmetric trade”. That is what we see with Orthofix (NASDAQ:OFIX).

As I will categorically demonstrate, an impending FDA action will send Orthofix stock at least 50% lower in the near future. The documentation below, along with new developments just in recent weeks, shows why I am 100% confident that this is going to happen. Just watch.

Orthofix knows that this is coming and Orthofix is scared. The company engaged a well known lobbying firm, and total payments for this effort now exceed $1 million. The recent lobbying effort appears to have failed. The process is now getting to the late stages and has continued through several important milestones, even in recent weeks. Yet Orthofix has made no adequate disclosure to investors.

Against this downside, Orthofix has virtually no visible upside potential from current levels. According to management, Orthofix already has a #1 market share in BGS (its main product) and the entire size of that market is only $500 million. The market for BGS is rock stable and is only growing by 1-3% per year. For each of these reasons, there is simply no chance of Orthofix pulling in unexpected windfall gains in BGS. Orthofix’s other businesses are either low margin and / or are facing accelerating declines amid soaring competition. As a result, I see no visible chance of an upside stock price surprise in being short Orthofix. Likewise, for longs, once the FDA thesis is understood, there is absolutely zero reason to continue owning the stock (not even in the $20s).

For shorts, clear evidence of significant and recent accounting manipulation, artificially boosting reported numbers, is just icing on the cake. This means that the downside in the share price will come sooner rather than later. Without that manipulation in Q3, Orthofix would already be trading at well below $30 (even prior to the FDA action).

What really makes this trade a “unicorn short” is that it has been totally undiscovered (until now). Neither longs nor shorts appear to have caught on to just how soon or how far this stock is going to fall.

There are very few institutions with a meaningful presence in Orthofix. The ones that were there in early 2016 have already been slowing liquidating during the year due to steadily worsening financial results across Orthofix’s other businesses.

At the beginning of 2016, Consonance Capital and North Tide Capitalwere both 10% and 5% holders respectively. As of September, Consonance had already cut its position size by 60% while North Tide had exited completely. Blackrock and Vanguard (i.e. the “dumb money”) each own 7%.

(Incidentally, last year Consonance was also one of the largest shareholders of Osiris Therapeutics (NASDAQ:OSIR). Shortly after I publicly exposed my fraud concerns at Osiris, the company was forced to restate its financials, the CEO was forced to resign and an SEC investigation ensued. Osiris subsequently fell by as much as 70%.)

In any event, despite the slow and steady liquidation, no one has yet run for the exits at Orthofix. As a result, the stock remains grossly overvalued. There is also virtually no short interest in the stock whatsoever. There are millions of borrowable shares for shorting and the negative rebate on those shares is only 40 bps (almost free). I expect at least 50% downside in the near term. Perhaps more over the longer term.

On the research side, the only real coverage comes from JMP Securities and Jefferies. But JMP rates Orthofix a “HOLD” and does not even include a price target. Jefferies rates Orthofix a “BUY” but has not even updated its coverage in almost 5 months, not even after the most recent earnings declines and visible declines in the other business lines.

The point is that neither JMP nor Jefferies are really doing much work on Orthofix or even really paying attention. Given this, no one should be surprised that they have totally missed this upcoming FDA issue or the accounting manipulation. When the stock price collapses to $15-17, they will simply pull their coverage.

Company Overview

Company: Orthofix

Business: Orthopedic Medical Devices

MarketCap: $700 million

SharePrice: $37.00

LTMRevenue: $406 million

LTMProfit: $14 million

Cash balance: $46 million

PERatio: 50x

NetSales: Stagnant / declining

Stockborrow: Over 1 million shares at Interactive Brokers alone

ShortInterest: 444,000 shares (only 2.6% of shares outstanding)

Options: Liquid calls and puts

Sales over 5 years have been entirely stagnant.

(click to enlarge)

Legal background – preview

Anyone who has followed Orthofix is well aware of the company’s troubled background with regulators and investors. Over the past few years, Orthofix has paid approaching $100 million to settle a wide variety of criminal violations and lawsuits for accounting misstatements and outright fraud.

Orthofix is fond of stating that “10 out of 11 of our management team are new to Orthofix”. So presumably the past problems are all behind them. But in Appendix I, I will show how there are actually numerous individuals from the bad old days who are still in the same senior roles at Orthofix.

Keep in mind that Orthofix’s past fraud and criminal behavior are NOT the crux of the current short thesis. These problems were bad. Really bad. But by now they are all well known and fully disclosed.

The crux of the short thesis is that the impending FDA ruling and the current accounting manipulation are far more relevant to the share price than the past fraudulent behavior.

The reason that I am highlighting this troubled past at all is that Orthofix continues to mislead investors in a very significant way, but now it is just about different issues. I am trying to highlight the pattern.

I will demonstrate below that Orthofix is 100% aware of the impending FDA down classification of its most important product. Orthofix even hired a lobbying firm (King & Spalding) to try to sway the FDA (I have included a copy of the letter from King & Spalding, along with links detailing over $1 million in payments). That lobbying effort appears to have failed badly and the down classification is still on track. There have even been new developments in the past few weeks. But despite its knowledge and the huge significance, Orthofix has failed to appropriately disclose any of this to investors.

In addition, I will show clearly below how Orthofix has been manipulating its financial results by pulling various accounting tricks. There is very limited sell side coverage on Orthofix and none of these analysts have adequately caught or highlighted the accounting manipulation. Had Orthofix not performed such manipulation in Q3, the stock would already be well below $30.

So again, just to be clear, Orthofix’s past history of Medicare and accounting fraud are not the dominant reason behind my short thesis. But for those who are new to the Orthofix story, you should at least be aware of the key highlights.

First, 4 years ago Orthofix was found guilty of massive Medicare fraud.

Following that discovery, Orthofix and various individuals pled guilty to obstructing a Federal audit which was investigating the fraud. More criminal charges followed from that.

Orthofix ended up settling with the DOJ and paying over $40 million in penalties. As part of the settlement, the company entered into a “corporate integrity agreement” (“CIA”) with the DOJ in which it vowed to refrain from further illegal activity for 5 years.

Yet within just 1 year, it was already uncovered that Orthofix was involved in a massive bribery scandal in Mexico, in violation of the Foreign Corrupt Practices ACT (“FCPA”). The DOJ extended the terms of the CIA (requiring additional years of probation) and Orthofix paid large fines, vowing to change its act. Yet within 1 more year, Orthofix was involved in another bribery scandal in Brazil.

And then finally, we hit the worst of the worst. Then, making matters even worse, as of 2015, Orthofix was required to restate inaccurate financials which had been released in some or all of 8 different years including 2007, 2008, 2009, 2010, 2011, 2012, 2013 and 2014. This then resulted in a separate SEC investigation. Not surprisingly, class action lawsuits then followed.

According to the lawsuits, the misstatements were not an accident or oversight. They were a deliberate set of misrepresentations designed to boost apparent financial performance and thus the share price. Orthofix settled but would not admit wrong doing.

The pain from past frauds is still ongoing today. Orthofix has already paid over $14 million in 2016 alone (including in Q3) as a result of these past settlements and investigations. The total financial consequence are now approaching in $100 million. For those who are interested, I have included full details of these past frauds, along with links to the criminal indictments and news articles as Appendix I.

If investors had been actually holding out any hope for Orthofix, it would be because they are hoping that CEO Brad Mason can keep the company out of further legal trouble. Mason has been with Orthofix in various roles since 2003. During the peak of the fraud problems, he was working for Orthofix as a consultant and advisor. He had also served as Group President, North America, but was not implicated in the fraud.

Again, as I will demonstrate clearly, Orthofix is well aware of the impending down classification but has withheld this critical information from investors. Orthofix is also clearly manipulating its accounting numbers. As a result, in my opinion, the “bad old days” of Orthofix are not just a thing of the past.

Investment summary

Orthofix is a medical device maker specializing in orthopedics. The largest source of revenue for Orthofix comes from its BioStim Bone Growth Stimulators (“BGS”). Bone Growth Stimulators are an external device that use a pulsed electromagnetic field (“PEMF”)to help increase bone fusion in bone fractures, including spinal treatment.

Orthofix already holds the leading market share for BGS of around 35%. The other primary competitors are Bioventus, Biomet, and DJO.

Beyond just revenue, BioStim is by far the most disproportionately profitable product for Orthofix. BioStim accounts for the majority of profits (more than 53% of net margin) at Orthofix. In addition, BGS is also the driving force behind any growth at Orthofix.

As I will explain below, the sole reason that Orthofix can command such high revenues and profits for BGS is the fact that it is classified by the FDA as a Class III device. This restriction severely limits competition. New entrants would be required to get Pre Market Approval (“PMA”) and/or run clinical trials. This takes years and costs many millions of dollars. This high barrier to entry is why Orthofix had previously been able to charge Medicare as much as $4,000 for a device that only costs $100 to manufacture. But that is about to change radically.

Orthofix has several other product lines. But it is clear that none of them create a real reason to own the stock. The impending down classification of BGS is really all that matters. But for those who wish to better understand the deepening declines in Orthofix’s secondary businesses, I have included relevant details at the bottom of this article.

Orthofix’s distant second business had been Biologics (such as bone allografts) but this business is now being eaten away on two fronts as shown below. Margins remain semi-strong, but quarterly sales have now consistently shown declines rather than growth. And pricing has been under repeated pressure due to a sharply increasing impact from a newly introduced competing product from DePuy (a unit of med device giant J&J). Management has repeatedly stated that this segment is about to turn around and get better, and is then surprised each time it gets worse. In fact, further declines are about to accelerate.

Orthofix’s other business segments (Spine Fixation and Extremity Fixation) have shown much lower margins and / or size. There has also been substantial trending weakness. Compared to BioStim, these are largely undifferentiated and low margin commodity products such as spinal screws, plates, rods and bars. Their relative sales are shrinking rather than growing. In the most recent quarter, Spine Fixation revenues plunged by almost 17%. The Extremity Fixation business is not really run out of the US, it is run out of Italy and primarily sells outside the US. But the accounting systems is place are so bad that Orthofix has been forced to only recognize these sales on a “cash basis”. In other words, they only count the sales when the cash is actually received.

The only point is that there is no way that these much smaller and struggling businesses, which are now showing declines, are going to in any way offset the tremendous loss about to affect Orthofix’s main product, BioStim BGS.

IMPORTANT POINT:

The only real reason to own Orthofix stock is because of the high revenues, the high profits and the strong growth behind one single segment: BioStim BGS.

And now that is about to dramatically change.

So here is the kicker !

What no one seems to have figured out is that the FDA is about to “down classify” Bone Growth Stimulators (“BGS”) from Class III to Class II. This means that there is far less of a regulatory hurdle for new competitors to start marketing BGS. With a much lower regulatory hurdle, cheap competition will be able to flood the market driving down prices and stealing most of the revenues outright. What revenues remain will end up on razor thin margins.

The impact of unfettered cheap competition can be seen to be massive. Competitors will soon be able to manufacture competing devices at prices which are as much as 80% below Orthofix’s historical sales price.

Certainly no one on the sell side has properly highlighted this problem to investors. But this is because they simply haven’t done the work.

The prospect of down classification should become obvious to anyone who performs thorough research on Orthofix. Just read the documents and call the FDA and you will know right away.

In 2006, an FDA panel did actually formally vote to down classify BGS. That initial evaluation by the FDA was in response to a petition from a low-priced competitor (RS Medical) who wanted to enter the BGS market.

According to the FDA panel, BGS clearly met the criteria for down classification. As a result, the FDA panel voted to down classify. But then that vote was reversed following an aggressive lobbying effort by Orthofix and the other BGS manufacturers, using DC lobbying firm King & Spalding. For obvious reasons, they wanted to keep out the prospect of cheap competition.

But that was then. This is now. Literally everything has changed!

The process was gradual at first, but there have been significant recent developments over the past few weeks.

In 2012, there was a big change. Congress passed the Food and Drug Administration Safety and Innovation Act (“FDASIA”). The purpose of this act was to speed up and streamline the approval process while reducing regulatory burden to enhance competition and product availability. As a result of this Act, the FDA began “re-reviewing’ hundreds of medical devices for potential down classification.

In 2014, the FDA decided to revisit the down classification of BGS specifically. That is where the new process began.

As part of its 2014-2015 Strategic Priorities, the FDA specifically proposed that BGS be down classified. More recent developments over the past few weeks show that the date of reckoning is now getting much closer.

Keep in mind that by the time of the FDA’s Strategic Review, the FDA already had in its possession all of that lobbying information from Orthofix. Yes, they already knew all of the arguments raised by Orthofix’s lobbying firm. And yes, they still proposed to down classify BGS.

In 2015, the lobbyists once again responded for Orthofix. (Here is a copy of the letter that King & Spalding submitted to the FDA). Their arguments were largely similar to the past arguments raised. Effectively they are simply trying to raise technicalities and trying to create beneficial interpretations of language in the law. But as we will see below, the Class III classification for BGS just doesn’t make common sense. Following passage of the FDASIA Act above, it is clear that these technical objections are not gaining much traction.

And now just a few weeks ago, even after the newest lobbying submission and the inclusion of the historical submission, the FDA has chosen to proceed further with the process anyway.

And keep in mind that this time, it was the FDA that initiated the down classification. This was NOT in response to an outside petition. In other words, this is something that the FDA itself wants to happen.

IMPORTANT DEVELOPMENT:

Just as of October 1st , 2016 (about 10 weeks ago) the FDA just transferred the BGS down classification process to the specific department responsible for handling the down classification (the department of Orthopedics). I have spoken to this department at the FDA. The point is that the process is now “active”. The most important point is that the individuals within the FDA responsible for this evaluation are the same people who previously voted to down classify BGS in the first place.

These developments are all very recent and have NOT been disclosed by Orthofix, even though Orthofix clearly saw fit to hire and dispatch a lobbyist to attempt to fight the threat.

As soon as Orthofix loses its competitive “moat”, we will see revenue immediately fall by around 30% or more. But the much bigger problem is that these revenues are actually responsible for a far greater share of profits at Orthofix. So of much greater importance is the fact that profits (net margin) will fall by nearly half. Any prospects for growth at Orthofix will evaporate immediately.

Again, this lack of disclosure to investors should be viewed in the context of a company which has been busted for issuing false financials, defrauding Medicare, obstructing a federal audit and paying bribes in foreign countries.

By looking to the site OpenSecrets.Org we can actually find out that total payments to King & Spalding just for attempting to defend BGS. These payments now total over $1 million. So this is not a minor effort. This tells me that the perceived “risk” is very real and the consequences are very substantial. It also tells me that this event is important enough that it should be adequately disclosed to investors.

Perspective on conducting healthcare research

Above I mentioned Osiris Therapeutics. After I exposed Osiris, the CEO was forced to resign, the company had to restate its financials and an SEC investigation ensued. The stock cratered by as much as 70%. All of the information in my article was obtained from publicly available sources that should have been available to anyone.

Earlier in 2016, I wrote an article where I stated that I was highly certain that medical device maker OraSure was going to lose a major, multi-year contract with AbbVie (NYSE:ABBV) within just the next few days. This contract was very important, because it accounted for over $40 million and more than 100% of Orasure’s net income.

It was well known that the contract was up for review, with a notification date of July 1st, but sell side analysts kept assuring investors that the contract was safe. Recent support from the sell side had pushed the stock up by 10-15%.

A number of skeptical readers stated that there was simply no way I could know for sure that OraSure was losing this contract in advance, and that I was simply “talking my book” to benefit my short position.

Instead, within just 24 hours (July 1) management arranged a hasty pre-open conference call to announce the fact that they had indeed just lost that Abbvie contract. Their announcement was clearly made as a direct response to what I had exposed in my article.

Once again, my skeptics were equally unhappy. Now they were insisting that they only way I could know this was though some sort of inside information. Obviously that is not the case. The research underlying my article should have been self evident.

I have undergone a similar process with Orthofix and I am now 100% confident that we will see an FDA down classification in the near future.

Similar research was beneath my short-pick articles on the following healthcare stocks which went on to decline as follows: (my point is that actually doing research really works).

Note: There is a 6 month “tail” on the revenues at OraSure, such that the company has not yet hit the revenue cliff. Some investors still haven’t figured this out. That, combined with some misplaced Zikka hype, have continued to support the share price. But I expect at least 40-50% downside from current levels.

No one should have been blindsided by any of these stocks. Links to my articles are included in the table above for those who wish to revisit the thesis prior to the sharp declines.

How important is BioStim BGS to Orthofix ?

(Overwhelmingly, extremely important !)

Orthofix’s business is divided into 4 segments (“SBUs”).

BioStim

Biologics

Extremity Fixation

Spine Fixation

The charts below show how Orthofix is overwhelmingly dependentupon BioStim.

The points to be made are as follows:

BioStim is the largest revenue generator

BioStim is also (by far) the largest profit generator in terms of net margin. This is due to its disproportionately high gross margin.

BioStim is the only unit showing any growth

BioStim has been increasing as a percentage of revenue

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Again, it is worth repeating: BioStim BGS is the largest revenue segment, it is responsible for more than 50% of profits, it represents the ONLY growing business segment, and it has been increasing as a percentage of revenue.

BioStim BGS is absolutely, positively the ONLY reason that anyone owns Orthofix.

Looking at Class III vs. Class II – recent developments

Documentation included below clearly indicates that BGS will be down classified. But before we get into that, it is worth understanding the logic here. It should quickly become clear that BGS should simply not be a Class III device. Common sense (and the FDA) will make this clear.

Bone Growth Stimulators are an externally worn device which emits an electronic pulse which enhances bone fusion. The devices are currentlyclassified by the FDA as Class III devices.

Class III is the highest classification for medical devices and is reserved for the most risky devices. Such devices must typically be approved by FDA before they are marketed. For example, when explaining its classifications, the FDA cites replacement heart valvesas a typical Class III device.

Getting approval for a Class III device is very time consuming as well as very expensive. As such, this has kept lower priced competition from entering the market. This lack of competition has allowed Orthofix to charge premium prices and capture the largest market share among a very small number of competitors. In the past, we have seen Orthofix charge as much as $4,000 for a device which only costs $100 to make.

So what does a real Class III device look like ?

The FDA cites heart valves as a Class III example for a reason. First, (clearly) heart valves are internal devices which must be surgically implanted. Second, any problem with a heart valve has a high likelihood of causing death. In other words, Class III devices such as heart valves are very risky and this is why they are treated as Class III.

Other devices (such as external devices, not surgically implanted and not life threatening) are clearly far less risky than this. This is why they are treated as Class II.

As part of the Food and Drug Administration Safety and Innovation Act(“FDASIA”) of 2012, and in order to help increase competition and improve availability, the FDA has begun a large effort to down classify various devices. This allows such devices to be marketed with far less onerous requirements. (Please note that this Act was passed AFTER the previous attempt at down classification on BGS. In other words, since that time, there is a new and enhanced effort by the FDA to down classify less risky devices).

As noted at the FDALawBlog, as part of its 2014-2015 Strategic Priorities, the FDA’s Center for Devices and Radiological Health (CDRH) committed to assuring the “appropriate balance between premarket and postmarket data collection to facilitate and expedite the development and review of medical devices.”

The FDA assembled a large list of devices for potential down classification.

Very quickly (by 2015) the FDA immediately rejected the obvious candidates. These devices were ones which should certainly remain as Class III devices. As noted, the FDA quickly declined to make any change to the status of 96 devices which were already Class III and were up for consideration.

(The point is this: if the FDA were going to reject down classification of BGS outright, they would have already done so…).

After the initial round of rejections, the FDA did propose to down classify 21 specific product codes, listed here. As is clearly shown, Bone Growth Stimulators (product code: LOF) are included on that list of 21 candidates which the FDA proposed to down classify. The complete list has been included as Appendix II below.

Following this, we can see from the FDA’s website that so far, that the FDA has already down classified 17 different products. The “hit ratio” therefore appears to be very high for products on this list. If they made the list, then they are going to be down classified. The down classification initiative at the FDA is still ongoing. Already in 2016, the FDA has down classified 7 more devices.

But wait, it gets better.

The products just successfully down classified in 2016 are obviously very similar in nature to the Bone Growth Stimulator. For example, here is the final order in 2016 down classifying External Pacemaker Pulse Generators. Here is the final order in 2016 down classifying External Cardiac Compressors.

Just as with BGS, each of these devices are:

– External electrical devices

– Not surgically implanted

– Not life threatening

In any event, so far, it looks as if nearly every device that made the proposal list ends up being down classified. This is especially true of the devices that are similar to BGS.

So what does the FDA say ?

Again, I did contact the FDA’s department of Orthopedics, which I confirmed is responsible for reviewing the classification. Obviously, they aren’t going to tell me the result of any final order until it comes out, but some useful information can always be had by calling. I am highly confident that the sell side has made no such effort prior to putting out their perfunctory reports (all of which are now outdated). Go ahead, ask them.

The biggest thing I learned was what seems to explain the delay so far in down classifying BGS. The process had previously been assigned to the department of Neurology and Physical Medicine. This was the wrong department. Just as of October 1st, 2016 (just 10 weeks ago) I was told that the process had been transferred to the department of Orthopedics.

First off, this makes much more sense, given that BGS are an Orthopedic device.

Second, it explains why the down classification hasn’t already happened.

Third, it tells me that the process is still proceeding on course towards down classification.

Perhaps of greatest importance is the fact that I was told that the team reviewing the down classification includes many of the same people from the team that had previously voted to down classify BGS in prior years. These people already know all of the arguments raised by Orthofix’s lobbyist and they have chosen to proceed anyway.

BGS down classification – chronology summarized

2006 – FDA proposes to down classify various medical devices including BGS from Class III down to Class II in order to streamline approvals, stimulate competition, improve availability and lower prices. The proposal to down classify BGS was prompted by an external petition to the FDA from medical device maker RS Medical which wanted to make competing lower cost devices. FDA panel initially votes to down classify BGS based on evidence.

2006 – Massive lobbying effort to the FDA by King & Spalding to reverse the vote succeeds. Vote is reversed and BGS not down classified. (King & Spalding is a D.C. based lobbying firm which represents Orthofix and others in front of the FDA).

2014 -Following passage of the FDASIA Act, the FDA begins a Strategic Review in which it seeks to down classify various devices. The FDA quickly proposes to down classify BGS (product code: LOF). But this time, the FDA took its own initiative to down classify and was not prompted by any external petition.

2015 – King & Spalding again submits its arguments against down classification in 2015, focusing on technicalities.

2015 – By the end of 2015, the FDA declines to down classify 96 medical devices which it believes should remain Class III. However, an additional 21 devices (including BGS) are placed on the list of devices proposed to be down classified. By December 2015, FDA announces that it had already completed itsevaluation of 100% of the devices on the list.

2016 – After evaluation period was completed in 2015, FDA formally down classifies 7 devices more so far in 2016 (so far, as of July 2016). This takes the total to 17 devices so far. The FDA repeatedly down classifies external devices which are not life threatening (similar to BGS). The down classification process continues to be ongoing.

2016 – In October, FDA transfers the down classification process for BGS to the department of Orthopedics, including the same people who previously voted to down classify BGS. Again, the FDA has continued taking these steps even after it has received all of the lobbying arguments from King & Spalding.

Where are the disclosures from Orthofix

Again, back in the “old days” (actually just a few years ago), Orthofix was found guilty of Medicare fraud, of obstructing a Federal audit, of bribery in two different foreign countries. It then came out that multiple years’ worth of financials had been falsified and needed to be restated.

But supposedly the past is behind us.

If the threat of BGS down classification merits $1 million in total payments to a lobbying firm in DC, then it certainly must be both highly likely as well as very severe in its consequences.

Orthofix is clearly very concerned, yet there has been no sufficient warning to investors.

Looking at accounting manipulation

I spend a lot of my time analyzing financial and accounting information. But I am not a CPA. As with everything else in this article, the analysis below is just my opinion. And in my opinion, the manipulations below were very stealthy. But once you know where to look, they become downright obvious.

Let’s start with the old accounting anecdote:

A businessman was interviewing job applications for the position of manager of a large division. He quickly devised a test for choosing the most suitable candidate. He simply asked each applicant this question, “What is two plus two?”

The first interviewee was a journalist. His answer was, “Twenty-two”.

The second was a social worker. She said, “I don’t know the answer but I’m very glad that we had the opportunity to discuss it.”

The third applicant was an engineer. He pulled out a slide rule and came up with an answer “somewhere between 3.999 and 4.001.”

Next came an attorney. He stated that “in the case of Jenkins vs. the Department of the Treasury, two plus two was proven to be four.”

Finally, the businessman interviewed an accountant. When he asked him what two plus two was, the accountant got up from his chair, went over to the door, closed it, came back and sat down. Leaning across the desk, he said in a low voice, “How much do you want it to be?” He got the job.

Accounting manipulation – the smart way vs. the dumb way !

Again, the crux of the sell thesis on Orthofix is that the FDA will down classify BGS and then revenues and profits for Orthofix will quickly evaporate. As soon as the FDA makes that announcement, we will see Orthofix trade to $15-17.

But as a separate issue, the visible accounting manipulation is just icing on the cake for this short trade. It means that even if we briefly ignore any impact from the FDA, Orthofix should still be trading well below $30 – TODAY !

Looking back at the history of Orthofix, we can see that the company has often employed a wide range of devices in order to get its financial numbers up.

Note that Q2 results were a notable disappointment causing the stock to sell off by nearly 20%. Then in Q3 numbers were again a disappointment due to each of the non-BGS businesses performing poorly. Note that these results were STILL a disappointment even though they were actually boosted by the manipulations shown below. As a result, the stock fell again. Without the manipulations below, the numbers would have been much worse. We can see that in reality, Orthofix should be trading well below $30.

Obviously Q3 was another disappointing quarter for Orthofix. The only “saving grace” for Orthofix in its bad Q3 numbers was a sharp spike in its reported adjusted EBITDA. But so far no one seems to have caught on to the accounting tricks used to achieve this.

For Q3, Orthofix reported $23.5 million in EBITDA. It was a notable surge in an otherwise bad quarter, and seemed to indicate that the declines were perhaps not as severe as we might think.

But as shown here, the real number should have been $18.65 million, not much of a surge at all. As a result, Orthofix was able to boost its EBITDA by almost $5 million, or 26% by using artificial devices. As for the analysts, they either didn’t catch these moves or else they simply didn’t care.

Keep in mind that there are two ways to go about manipulating one’s accounting numbers: the smart way and the dumb way.

The dumb way is to figure out how big of a financial hole you need to fill and then conduct one gigantic revision right at the top or bottom line. This is the dumb way because it is so conspicuous that even the laziest of analysts and investors will be unable to ignore it.

Instead, Orthofix has manipulated its numbers “the smart way”. Orthofix finds multiple different levers which can be pulled. Each one is too small to really get much attention. In addition, each manipulation is derived from an area of the income statement which is not typically an area of heavy focus. As a result, no one catches on.

Infrastructure spending irregularities – $1.73 million = 9.3% boost

As readers of my past articles will remember, any time I come across blatant “mistakes” or “inconsistencies” in a company’s SEC filings, it should be cause for great concern. This is especially true when looking at the fraud in the backgrounds of the individuals as highlighted above. Not surprisingly, whenever I “catch them in the act”, I find that these “mistakes” or “inconsistencies” ALWAYS seem to benefit management and the financials. This was exactly what led to my exposure of Osiris Therapeutics and we are now seeing it again with the “mistakes” I have found in Orthofix’s SEC filings.

(Not surprisingly, these “mistakes” for some reason always seem to be of benefit to the company and not to their detriment. Go figure.)

In the Q2 form 10Q, Orthofix discloses that: “Over the life of the project the Company has spent$27.5mm, of which $18.6mm has been capitalized. We expect to spend an additional $1.9mm”.

But then in the Q3 form 10Q (3 months later), Orthofix disclosed that: “Over the life of the project, the Company has spent$26.6 million, of which $18.1 million has been capitalized. We expect to spend an additional $0.8 million over the remainder of the project.”

Did you catch that ?!?

In Q2, Orthofix stated that they had already spent $27.5 million. But 3 months later, somehow this historical numberactually went down after the fact to $26.6 million. Obviously the real world doesn’t work this way. But thanks to the magi of accounting, companies can always find a way to pull a rabbit out of a hat to help boost a bad quarter.

The difference here presumably runs straight to the bottom line, with a benefit of $900,000.

Here is where it gets really weird.

Even though the incurred cost supposedly declined after the fact, Orthofix still chose to add back an additional $827,000 to EBITDA and EPS as one time adjustments. This alone added 4 cents to EPS.

In total, the infrastructure manipulations benefited Orthofix’s EBITDA calculations by $1.73 million. (A boost of 9.3% from the base line number).

As you can see, the size of this one item is not massive and it was buried in a line item that likely no one (other than me) even focuses on. This is how the trick eludes attention from investors and analysts.

One time tax provisioning reversals – $2.4 million = 12.9% boost

This next lever was used to provide an apparent cut to Sales & Marketing Expense to abnormally low levels. S&M has typically run consistently around 45%. But in Q3, this was slashed to 42.4%. A large part of this was due to an accounting reversal of certain tax liabilities which flow through S&M. These are things like sales and use tax, property taxes, and other business taxes (ie. Not income taxes). Orthofix had provisioned this at the beginning of the year and then reversed it just in time to boost quarterly numbers as soon as results fell far too short. This is something that is entirely left to the discretion of management.

In total, the S&M tax manipulations benefited Orthofix’s EBITDA calculations by $2.4 million. (A boost of 12.9% from the base line number).

So again, a not-too-large accounting reversal in an area that doesn’t get much attention. So investors don’t really notice. But it is starting to add up.

Reversing allowance for doubtful accounts – $720,000 = 4% boost

In Q2, allowance for doubtful accounts was $9.56 million. But for Q3, that number was reduced to $8.84 million, resulting in a savings of $720,000. The allowance decreased not only in absolute terms, but also as a percentage of sales. So far I have found no explanation to justify this $720,000 benefit.

In total, change to allowance for doubtful accounts benefited Orthofix’s EBITDA calculations by $720,000. (A boost of 4% from the base line number).

Again, small enough to not raise flags and in a place where no one is looking.

Reversal of Obsolete Inventory – ???? = undisclosed size !

This one is great !

Orthofix had previously taken a reserve for writing off Excess & Obsolete Inventory (“E&O”). This amount or reason is not described in the financial statements so it is impossible to calculate just how much this boosted EBITDA. In any event, somehow Orthofix suddenly decided that formerly unsellable inventory (Excess & Obsolete) could now be sold. And, as always, this fortuitous development just happened to come along right when Orthofix was having a terrible quarter and needed to make its numbers.

In discussing E&O, Orthofix did disclose on the conference call that gross margin had been boosted by around 1%. As a result, we can estimate this artificial benefit at around $1 million. (1% of approximately $100 million in sales).

But since I can’t document the calculations, I am just ignoring this last item.

So even without the extra million from E&O, we can see that EBITDA was boosted by 26%. None of these items was big enough to stick out on its own and none of them really occurred in any key area of focus for analysts or investors.

Everything was cleverly kept below the radar, and the headline of soaring EBITDA reads great in an otherwise very disappointing quarter.

Beyond BioStim BGS – looking at the Biologics segment

Looking at the information above, it becomes clear that the only real reason that anyone owns Orthofix at current prices is because of a misplaced confidence in BioStim. And when the FDA moves to down classify Orthofix, that reason is going to be decimated.

In the past, there was sometimes a second reason to own Orthofix and that was its Biologics business.

Biologics mainly consists of bone allografts and tissues, including Trinity Elite and Trinity Evolution, which are “derived from human cadaveric donors”. (i.e. harvested from dead people).

(Incidentally, this happens to be the same business that Osiris Therapeutics is in, so it is one that I understand quite well.)

Orthofix’s bone allografts are mainly comprised of its Trinity ELITE and Trinity Evolution products. These contain viable cells and are used in surgery in the treatment of musculoskeletal defects for bone reconstruction and repair.

But keep in mind that Orthofix doesn’t actually PRODUCE these products and does not even own the IP.

In reality, MTF does all the work and then Orthofix just charges a “marketing fee”. The revenues are not enormous but the margins appear to be high because there is no cost of goods sold. There are of course heavy selling costs.

MTF processes the tissues, maintains inventory, and invoices hospitals and surgery centers and other points of care for service fees

In the past, this segment was attractive for two reasons. First, because Biologics afforded high net margins of around 50%. Second, in the past, this segment also used to show appreciable growth. For example, from FY2014 to FY2015, Biologics grew by 7.1%.

This has now begun to dramatically change along with the adoption of a competing product called Vivigen from Depuy (part of J&J). And it is about to get worse.

When Depuy’s Vivigen product was launched last year, it was quickly named among “THE NINE BEST NEW SPINE TECHNOLOGIES FOR 2015“. And as soon as its sales started to gain traction, it began to have an appreciable effect on Orthofix’s Biologics division.

Here is a quote from that award:

ViviGen is the first cellular allograft to focus on recovering, processing and protecting viable lineage committed bone cells. New evidence supports the use of bone cells instead of MSC’s for bone healing. It is made of viable cryopreserved corticocancellous bone matrix and demineralized bone. Because of its properties, ViviGen can be considered to be an alternative to autograft.

And here is what began happening to Orthofix’s Biologics sales just after Vivigen was launched.

(click to enlarge)

Last year, Biologics was growing by over 7%. Then Q1 continued to show slight growth, but just barely. But then Q2 got hit hard with a 6.7% decline in Biologics sales. Here is what management had to say on the Q2 conference call:

Net sales in our Biologics SBU declined 6.7% for the period due to our reduction in Trinity volume, which was primarily a result of an exclusion from a large national hospital account, as well as an increase in competing product offerings.

We remain optimistic about this SBU returning to growth in Q3 and Q4 and achieving growth in the low-single-digits for the full year.

Note that despite managements “optimism” about a recovery in Biologics into Q3, we can see that Biologics sales declined again in Q3.

Management then changed its views on the entire business. On the Q3 conference call, management noted that:

Considering our result over the last few quarters in our Biologicsbusiness, we’re now anticipating a low to mid single-digit DECREASE in year-over-year net sales for the fourth quarter and full-year 2016.

The reality is that Biologics is getting hit on two fronts. Anyone who is familiar with this business (including Osiris, Orthofix and Depuy) knows that it is a business that is gradually getting more competitive and less profitable each year. It is getting worse rather than better.

Extremity Fixation Segment

Even in a good quarter, Extremity Fixation only represents around 20% of profits for Orthofix. This is somewhat of a niche business where Orthofix already commands a large market share. As a result, easy opportunities for growth are very limited, even though quarterly results are often volatile.

Orthofix was originally founded in Italy a few decades ago and was focused on the Extremity Fixation business. These devices consist of pins, rods, bars and screws to hold bones in place after complex fractures. They are used for things like deformity correction and limb lengthening. In contrast to the Spine segment below, these devices are primarily used externally.

Orthofix continues to sell these devices, but the business is largely run out of Italy. Around 80% of the sales are non US sales. Obviously the rising US dollar has not been kind to the results for this segment. As a result, management repeated discloses the “constant currency” results which naturally appear much better on paper. But in reality, this means little for dollar denominated investors in a US company which reports in dollars.

This segment has a history of accounting problems. The segment cites limited visibility for the fact that it has been forced to use “cash basis” accounting to account for all sales. In fact, this is almost exactly what we saw at Osiris not long before the SEC investigation. It was part of my original short thesis on Osiris prior to the 70% plunge in the stock.

The cash collection policy means that revenue reporting is very lumpy and volatile. The past 2 quarters showed decent apparent growth. But this was largely because they were being compared against an easy previous comp when cash collections had been low.

Anyone who has historically been long Orthofix is certainly not banking on Extremity Fixation to move the needle.

Spine Fixation Market

Orthofix acquired the Spine Fixation business back in 2006. The company now provides a fairly full range of spine fixation products, including screws, rods, and plating systems, etc. In other words, this is a “hardware” business.

This is effectively a higher volume, low margin, commodity hardware business. Total profits from this segment amounted to just 6% of total profits for Orthofix.

One thing to note is that management discloses that 65-70% of the Spine Fixation sales actually go through the Biologics sales force.

So in other words, when the sales force is selling higher margin bone allografts, they then attempt to bundle in some sales of low margin spine products.

But following Depuy’s launch of Vivigen, Orthofix’s Biologics sales have been getting hit hard. This therefore has an even greater impact on Spine Fixation because it is such an undifferentiated product.

As a result, Spine Fixation revenues fell 17% YOY in Q3. Without a strong Biologics offering, Spine is going to be a product that is harder and harder to sell.

Again, certainly no investors are banking on this small segment to move the needle for Orthofix.

Conclusion

Because BGS are classified by the FDA as Class III medical devices, there is very little competition in the space. As a result, Orthofix can charge ultra high prices and still command a huge market share.

The FDA has proposed to down classify BGS to Class II status, which would make it easier and cheaper for competitors to offer similar devices. Cheap competition will flood the market at a fraction of the cost.

Timing is uncertain, but given the latest developments in October the down classification could come quite soon.

King & Spalding is a DC lobbying firm that represents Orthofix and others in front of the FDA. The firm has already been paid over $1 million for its attempts to influence the FDA to not down classify Bone Growth Stimulators. The risk and the consequences for Orthofix are big, they are real and they are near. This is why over $1 million has been spent. Yet investors have not been adequately warned.

Orthofix’s significant history of Medicare fraud and accounting misstatements are not the crux of the short thesis. But they should serve as food for thought regarding why the FDA issues have not been adequately disclosed to investors.

I believe that the down classification of BGS is a virtual certainty. First of all, it just makes common sense. Second, we can see from the FDA’s actions that they have continued to proceed with down classification through multiple milestones, including in recent weeks. Third, the FDA has recently been down classifying multiple very similar devices.

Back in 2006, the lobbying effort by King & Spalding succeeded. The FDA had already decided that the evidence indicated that BGS should be down classified. But King & Spalding was able to get the FDA to actually reverse its decision.

Following that Act, the FDA began to revisit hundreds of devices that should be down classified. Last year (2015), the FDA did immediately rule out down classification for 96 devices which it determined should remain as Class III. So if the FDA were going to not down classify BGS, they would have already made that decision.

The FDA then selected 21 devices which it proposed to down classify.

BGS are included on that “short list” of 21 items that the FDA wants to down classify.

So far, through 2016, the FDA has already down classified 17 devices. This includes 7 in 2016 and includes multiple devices that were very similar to BGS (external, electronic devices which are not life threatening).

King & Spalding sent in another lengthy letter to the FDA in an attempt to oppose the down classification, but the FDA down classification process has continued through multiple milestones since then.

In October 2016 (just 10 weeks ago), the FDA transferred the down classification process to the department of Orthopedics which is responsible for handling this.

I believe that BGS will definitely be down classified. As soon as the FDA announces this, Orthofix’s share price will trade to $15-17.

Recent accounting manipulations consisted of multiple items, each one of which was too small and too obscure for investors to notice on an individual basis. But in aggregate, they had a material impact on Q3 results. Without the benefit of this, Orthofix would already be trading below $30 (even before the FDA action).

The only sell side research on Orthofix comes from two firms who have issued brief reports which are already months outdated. They clearly are not following any of these developments.

BGS is responsible for more than half of the profits at Orthofix. Orthofix is overwhelmingly dependent upon BGS.

Each of Orthofix’s other business lines are facing unique challenges, pressures and declines. The only reason that anyone actually owns Orthofix is for the stable revenues and high profitability of BGS.

Again, as soon as the FDA down classifies BGS, I expect the share price to quickly trade to $15-17.

Please understand that the contents of this section are NOT a key part of the short thesis. I am simply including details on historical problems to demonstrate that various individuals have been present or involved in activities which blatantly deceived investors, consumers and or the government. The point I am trying to make is that there is a reason why investors have not been warned about the ongoing down classification proceedings. Investors should also consider this background when evaluating the section on accounting manipulation.

In the past, we can see a host of regulatory violations and outright fraud at Orthofix. This is a company that has been busted by the DOJ, the SEC, the department of Health and Human Services (“HHS”) and the OIG among others. The violations were as egregious as they were numerous and Orthofix was clearly found entirely guilty.

As would be expected, a number of individuals were fired dung the course of these investigations and indictments. A number of other individuals within management were criminally indicted themselves.

But surprisingly, given the severity of the fraud and regulatory violations, there has been a large degree of management continuity. Many of the same individuals are in place, still running Orthofix.

This management continuity needs to be kept in mind when evaluating recent developments, including failure to disclose very material FDA problems (which, as demonstrated, are fully known by management) as well as recent accounting manipulation in 2016.

Unfortunately, the reality is that fraud and manipulation are absolutely rife within the Med Device space in the US.

Just this week, Orthofix added a new board member, Alex Lukianov, who had formerly been CEO of spinal med device competitor NuVasive (NASDAQ:NUVA). Last year Lukianov was forced to “resign” as CEO following his “violations of personnel and expense reimbursement policies“. NuVasive has so far refused to disclose further details. However, just after his resignation NuVasive ended up paying millions to settle fraud charges with the DOJ involving violations during his time as CEO. According to the DOJ press release, “Defrauding Medicare and Medicaid by paying kickbacks to physicians and promoting uses not covered by Federal health care programs will not be tolerated“. In any event, after leaving NuVasive, Lukianov was in need of a job, so now he is a board member at Orthofix. Earlier in the year, Orthofix appointed Michael Paolucci to the board. Paolucci is another former NuVasive executive who had worked under Lukianov.

Already in 2016, Orthofix has incurred over $14 million of expense in relation to an SEC enforcement action which it was forced to settle over sweeping accounting misstatements and Medicare fraud. This includes millions in expense in the most recent Q3 alone.

Looking back, we can evaluate the relevant events between 2012 and 2015.

Violation #1 – Medicare Fraud (GUILTY)

In 2012, Orthofix pled guilty to civil and criminal Medicare fraud chargeswith the DOJ, including $42 million in fines. The fraud involved gouging Medicare for inappropriate an overpriced sales of its Bone Growth Stimulators (the main product at Orthofix).

In that suit it was noted that, “Orthofix made false claims for payment for certain items of durable medical equipment used by patients in their homes, in particular osteogenesis stimulators, covered by Medicare, Medicaid and other federal and state purchasers. Medicare would pay approximately $4,000 to purchase a device that costs only $100 to manufacture.” Currently Orthofix is still “onprobation” as a result of that guilty plea. Orthofix discloses that, “In the event that we fail to satisfy these terms of probation, we could be subject to additional criminal penalties or prosecution, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.”

Violation #2 – Obstruction of a Federal Audit (GUILTY)

From looking at the website for the FBI, we can see that in connection with their Medicare fraud, Orthofix was also found guilty of obstructing a federal audit in an attempt to cover up the fraud. In the end, at least 9 doctors were also charged in the fraud ring.

Despite the tremendous legal exposure from ongoing “criminal probation”, they continued to commit other flagrant violations.

Violation #3 – Paying Illegal Bribes in Mexico (GUILTY)

Orthofix later settled with the DOJ over violations of the Foreign Corrupt Practices Act where it paid bribes to win business in Mexico. Not only was Orthofix prosecuted by the US government, but it also paid $4 million to the Mexican government.

Orthofix entered into a “deferred prosecution agreement” which stated that the company must refrain from future violations for 3 years or face additional penalties. But within just 1 year (in 2013), the company was already investigating improper foreign payments in another country, this time in Brazil.

As a result, Orthofix was then currently embroiled into a DOJ investigation which encompassed illegal payments in both countries.

But wait, it gets better.

Violation #5 – Accounting Misstatements (8 years !)

Then in 2015, the company completed a multi year financial restatement due to accounting misstatements which then became part of an SEC investigation. Amazingly the, accounting misstatements were gigantic and covered misreported numbers over a tremendous timespan, including 2007, 2008, 2009, 2010, 2011, 2012, 2013 and 2014 ! That is 8 years containing misstatements!

I have demonstrated Orthofix’s clear knowledge of this impending crisis. Yet investors have not been adequately warned. This event clearly merits its own very prominent risk factor in Orthofix’s financials, yet this has not been done. Orthofix should also be spelling this event out to investors in its presentations and conference calls. Again, this has not been done.

Those with a good view on Orthofix’s regulatory history are likely NOT SURPRISED but this omission.

They should also not be surprised by recent accounting manipulation which has been used (including in the most recent quarter) by Orthofix to meet Wall Street estimates and boost the share price. Orthofix management throws in every accounting gimmick but the “kitchen sink” in order to manipulate their apparent financial results. Overall, Orthofix recently inflated its adjusted EBITDA by as much as 26% using pure accounting tricks.

Appendix II – product codes to be down classified by FDA

Product Code

Description

LFD

Saliva, artificial

LLX

Catheter, sampling, chorionic villus

LMF

Agent, absorbable hemostatic, collagen based

LNC

Applicator, hyperthermia, superficial, rf/microwave

LOA

Device, testicular hypothermia

LOB

Dilator, cervical, synthetic osmotic

LOC

System, rf/microwave hyperthermia, cancer treatment

LOF

Bone growth stimulator

LPQ

Stimulator, ultrasound and muscle, for use other than applying therapeutic deep

The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of healthcare companies including medical device, pharmaceutical, genomics and biotech companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in OFIX and during the past 12 months has shared his fundamental and/or technical research with investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied

Nymox moved its domicile from Canada to the Bahamas to limit transparency and legal liability. No institutional ownership or research coverage by anyone.

Nymox is down to $800,000 in cash and has just $41,000 in quarterly revenues. Bogus misleading press releases have caused the stock to recently soar.

Authors note: Prior to publication, the author filed a formal written whistleblower complaint with the United States Securities and Exchange Commission (“SEC”), including details from the article below.

Investment summary – catalysts for a decline to true zero.

The key points I will make in this article are as follows:

Nymox management has consistently and repeatedly misled shareholders about its prospects in a material way – and then dumped stock at inflated prices without making timely SEC disclosures. The stock price then crashes.

Following the ensuing fraud lawsuits, Canadian Nymox reincorporated in the Bahamas to limit disclosure and legal liability. It then quickly resumed its promotional activities from the Bahamas.

Nymox has a history of using anonymous offshore Panamanian financiers who then fail to disclose share ownership or their unregistered offshore dumping of stock.

Unremedied material weakness in internal controls, a “going concern” warning and a highly problematic penny stock auditor of past stock promotions. Auditor Thayer O’Neal is simply a renamed “spin off” from previous auditor who was dissolved by the PCAOB for gross audit deficiencies.

Nymox’s legal counsel has recently been charged by the SEC with stock fraud, engaging in pump and dumps and market manipulation. He has a long history of such activities.

Nymox’s banker has a long history of involvement with penny stock promotions and blatant SEC violations when raising money for microcaps. Significant history of their troubled clients going to zero after raising money from investors.

The doctor who was quoted in the recent bullish Nymox press release failed to disclose his direct funding from Nymox as well as ownership of shares.

More details on repeated small purchases by new board member James Robinson

Nymox Pharma (NASDAQ:NYMX) is a “no-brainer” short which I expect to go to true zero. The company bears many striking similarities to Forcefield Energy (NASDAQ:FNRG) which quickly collapsed by 99% within a few days following my exposé of that company.

Multiple parties behind Nymox have been behind other stock promotions which have declined by at least 99%.

Shares of Nymox Pharma had nearly doubled this year as a result of several grossly misleading press releases issued by the company. The shares are now up by nearly 10x from their 2015 lows.

Nymox has been around for over 30 years but has failed to ever have a commercial success. In November of 2014, the company announced that its only clinical drug (NX-1207) had failed both Phase 3 clinical trials it was in, sending its stock to as low as 39 cents. However, Nymox management had in its possession the information that the trials had failed for as long as 6-12 months prior to releasing the news to the public.

During that time (well after the drug had failed), Nymox management continued to put out bullish press releases while dumping millions in stock without making timely SEC disclosures of the sales. During this time, Nymox also raised millions more for the company by placing unregistered stock with an anonymous offshore Panamanian shell company. The Panamanian shell has never disclosed its ownership and has never disclosed its sales of stock.

On the legal side, Nymox is represented by Zouvas & Associates LLP. Luke Zouvas was previously a partner with Luis Carrillo in the firm Carrillo Huettel & Zouvas, LLP. That firm imploded when Carrillo was charged by the SEC in a wide range of small cap pump and dump fraud schemes involving Canadianstock promoters and Bahamas based brokers.

(Note that Nasdaq listed Nymox was originally a Canadian company. In order to avoid legal scrutiny and liability, Nymox recently (July 2015) re-domiciled itself to the Bahamas.)

Zouvas himself can now be tied to numerous small cap pump and dump stock promotions and was just recently (April 2016) charged by the SECfor outright stock fraud using offshore companies, undisclosed ownershipand sales of stock, as well as false and misleading press releases issued by the company.

Nymox has quarterly revenues of less than $50,000 and is down to less than $1 million in cash. The company has had unremedied material weaknesses in internal controls for over two years and has a going concern warning.

Nymox’s auditor, Thayer O’Neal was created as a direct spinoff of LL Bradford, when that firm was recently shut down by the PCAOB for multiple gross audit deficiencies. The new “spin off” auditor simply changed its name and picked up LL Bradford’s troubled clients, all of which (aside from Nymox) have imploded to just pennies.

Nymox’s banker is Chardan Capital markets. Chardan and its founders have a lengthy history of run ins with regulators, including cases of market manipulation, numerous imploded reverse merger frauds and charges of defrauding the Small Business Administration.

Similar to Forcefield Energy , Nymox “appears” to have just 1% institutional holdings with the rest “supposedly” being scattered among small retail holders. Nymox has zero research coverage. Following my exposure of Forcefield, the share price plunged 60% within 3 days. The Chairman was then quickly arrested by the FBI for manipulating the worthless stock. After being halted, Forcefield quickly fell to zero. I believe that with Forcefield there were large holdings of stock being held by undisclosed offshore holders. These holders were well aware that the company was a sham and were the first to dump shares at any price as soon as I exposed the promotion. There was simply no value in the company and no bottom in the share price.

In the last section below, I will also provide more information on recent share purchases by an 81 year old Hollywood film director (James Robinson) who was appointed to the board of Nymox in 2015.

Background

Over the past few years, I have exposed a wide variety of deeply troubled companies. I have highlighted these companies as attractive targets for short selling opportunities. Following exposure, many of these companies quickly plunged by 80% or more. Examples of my “targets” which subsequently plunged by at least 80% include:

But in fact, I have also exposed dozens of others which also quickly fell by at least 50%. This can be seen by looking at a list of my prior articles. While not the epic homeruns, I would also consider drops of 50% or more to be very successful short trades.

In my earlier career years, I spent nearly a decade as an investment banker for a major firm on Wall Street, with a primary focus on healthcare companies, biotechs in particular. I performed due diligence on more companies than I can count and helped successful biotechs raise billions of dollars. I learned quite a bit about what separates “real” biotechs from the “wanna be’s”.

It is now many years later, and I have parlayed that experience into investing for my own account. I continue to focus heavily on biotechs and (as my regular readers know) I often focus on short selling opportunities, betting on declines in the share prices of biotechs which have underlying problems.

About 2 weeks ago, Shares of Tokai Pharma plunged by 80% in a single day when its prostate cancer drug (Galeterone) failed Phase 3 trials. This is yet another stock which I had warned investors about in late 2015. When I wrote about Tokai, the stock had been trading at around $10. I showed that Tokai was engaged in “after-the-fact cherry picking” of data and highlighted heavy insider selling. I described Tokai as a “no brainer short“.

Following my article, Tokai’s share price ground down to around $5.00 – an initial decline of 50%. Failure of its drug was all but guaranteed. Following the announcement of the failure, the stock now trades for around $1.00.

Today I am exposing very deep problems at Nymox Pharmaceutical . There are obvious similarities between Nymox and my past homerun short trades, especially Tokai Pharma and Forcefield Energy.

Nymox is another “no brainier short” which will soon go to true zero. Yes, zero. This is a company with no value and basically no assets which has simply been pumped up on promotional hype.

Nymox – recent developments

In late 2014, shares of Nymox Pharma had just rallied by 25% to over $5.00 as anticipation was building for the results of its two Phase 3 trials for its NX-1207. The trials had been evaluating NX-1207 for use in treating Benign Prostatic Hyperplasia (“BPH”), otherwise known as an enlarged prostate.

Much of the share price strength had been due to a stream of positive press releases from Nymox touting the strong prospects for NX-1207. Examples of these press releases are shown below.

Then on November 3rd, 2014, Nymox announced that both trials had both failed to meet their primary endpoints. The stock immediately plunged by 85% to just 75 cents. It continued to decline to as low as 39 cents in the subsequent weeks.

(Note: as I will demonstrate throughout this article, management was already aware that NX-1207 had failed Phase 3 trials as far back as 6-12 months earlier. Instead of making timely disclosure of the failure, management continued to put out bullish press releases touting the drug’s prospects. During this time Nymox CEO Paul Averback aggressively sold millions of dollars worth of stock at inflated prices, while Nymox the company raised over $5 million from equity offerings. No SEC disclosures of the sales were made at the time).

Since the implosion in November of 2014, the shares have now recovered much of those losses, now trading at around $3.20 In other words, the stock is now up by nearly 10x since its post-failure lows !

The key driver of the stock price rebound has once again been a series of NEW favorable press releases under which the company seems to suddenly indicate that (contrary to previous disclosure) the company’s only drug once again has bright prospects.

As I will demonstrate clearly below, the information in these press releases is deeply misleading. Nymox’s only drug continues to be just as worthless as it was when the stock was trading at 39 cents.

With just 1% institutional holdings and zero research coverage, there has been almost no analysis of the faulty information being disseminated by Nymox.

Investors should run (not walk) from this dubious biotech which has a long and sordid history of deeply misleading shareholders as management dumps shares.

Company Overview

Nymox Pharma was founded in 1985 (yes, over 30 years ago) by CEO Dr. Paul Averback. During the past 30 years, the company has pursued multiple business paths including various diagnostic tests as well as several initial attempts at therapeutic drugs. It has never generated meaningful commercial revenues. The company does generate a miniscule amount of revenue (less than $50,000 per quarter) from sales of two diagnostic tests which test for the presence of nicotine in saliva or urine.

Looking at Nymox’s financials, it may appear that the company has generated a decent amount of revenues over the past 5 years. However, this is absolutely, positively not the case.

Back in 2010, Nymox signed a licensing agreement with Italy’s Recordati Pharma. Recordati paid an upfront licensing fee of $13 million for European rights to Nymox’s only drug, NX-1207. Over the years, Nymox has disclosed working on several different drug compounds, but NX-1207 is the only one that ever made it into any clinical trials. At the time of the Recordati agreement, NX-1207 drug had just entered Phase 3 trials.

It is important to note that the $13 million in cash from Recordati is long since gone and Nymox now has less than $1 million in cash. However, for accounting purposes the Recordati revenues were recognized pro-rata over the subsequent 5 years. This gives the appearance that Nymox had generated around $2-3 million per year in revenues. But again, this is for accounting purposes only. Nymox generates less than $50,000 per quarter in revenue and now has less than $1 million in cash. Nymox has never generated meaningful revenues from commercial sales of any product.

Following the 2014 failure of both Phase 3 trials, Recordati immediately terminated all development and commercialization activities related to NX-1207.

As of 2016, we can see that Nymox is no longer recognizing these revenues for accounting purposes. In Q1 of 2016, Nymox revenues amounted to just $41,501.

Given its shaky financials and limited prospects, it is not surprising that there is virtually no institutional investment in the company. Institutional ownershipstands at just 1% of shares outstanding. There is no research coverage of Nymox. Share price moves are entirely driven by retail day traders who play the latest headlines and press releases on the stock.

Nymox has a long history of misleading investors – and then dumping stock at inflated prices

My regular readers will remember that I have exposed multiple biotech stock promotions at companies such as CytRx , Galena , Ziopharm , Northwest Bio and Tokai Pharma . These promotions shared many similarities to what we now see at Nymox. This will be illustrated below.

Each of these companies was dominated by the participation of retail investors and each of them had completed seemingly “promising” Phase 2 clinical trials. Many small investors relied heavily upon numerous bullish press releases which appeared to presage almost certain success of their drugs.

What many retail investors do not understand is that drugs do not “pass” Phase 2 and then proceed on to Phase 3. The progression from Phase 2 to Phase 3 is simply a DECISION made by the company. For companies running stock promotions, they will ALWAYS proceed to Phase 3, even when they know that their drug doesn’t work. This is because having a drug in Phase 3 typically results in a share price bump and allows the company to raise larger sums of money. We saw this exact phenomenon in each of CytRx, Galena, Ziopham, Northwest Bio and Tokai. And we are now seeing it again with Nymox.

In each case, management aggressively touted the “compelling results” in Phase 2 in order to boost the share price. When the share price bumped up, the companies could then raise more money and enter partnerships with larger drug companies. Insiders would often sell stock.

Yet in each case, the Phase 2 trials were largely a sham. In each of may articles, I showed with a high degree of certainty that each of these dugs stood almost no chance in Phase 3 trials. Yet management chose to proceed to Phase 3 anyway. When Phase 3 results were released, they were a dismal failure in each and every case. The share prices quickly plummeted by 60-80% in a single day.

Sadly, such misleading behavior is very common with small cap biotechs.

With no institutional investment and no research coverage, there is simply no mechanism to keep Nymox honest. The day-to-day share price action is strictly dominated by retail day traders who play the headlines and press releases of the company along with following “technical analysis” on places like Twitter.

Nymox (in particular CEO and founder Paul Averback) has a history of grossly misleading investors and then dumping shares at inflated prices.

During its 30 year history, past business descriptions detailed the company’s primary pursuit of Alzheimer’s related projects. This included a diagnostic testfor Alzheimer’s as well as several anti-Alzheimer’s drugs. Many years ago, Nymox had also done very preliminary work on developing several anti-infective drugs. But these never went anywhere.

Even in the distant past, Nymox and CEO Averback have always been very aggressive in promotion.

With the Alzheimer’s test, Averback had once run an aggressive public ad stating that “Alzheimer’s–Now you can rule it out“. An article in Bloomberg quickly described Averback’s ad as “misleading”, “unproven” and “unsupported”.

According to Bloomberg:

Dr. Norman R. Relkin, an Alzheimer’s specialist who directs a memory-disorders program at New York Hospital-Cornell Medical Center, says hawking the test to the public is “reprehensible.” The Alzheimer’s Assn. derides Nymox’ “highly objectionable” sales efforts and advises against use of the test

Following such public criticism of his marketing tactics on the ineffective test, Avervack then switched to using “scientific meetings” to spread use of the test, funding studies conducted in hospitals which it said were supportive.

In its rush to market, Nymox seems more interested in cashing in on the data it has rather than learning more.

However, the effect of the public promotion by Averback had a strong effect and Nymox’s stock soared from $2.45 to as high as $13.50, before ultimately crashing back to the $2’s.

The issue here was that the Alzheimer’s test proved to be highly problematic.

Nymox’ test had demonstrated a disturbing rate offalse positivesof 11%. At the time, Harvard Medical School neurologist Peter Lansbury noted: “A false positive for Alzheimer’s is a nightmare.” It would end up preventing diagnosis for various other types of impairment, which could have otherwise been treated if properly diagnosed.

In July of 2005, an FDA advisory panel voted 5 to 2 to block use of Nymox’s Alzhemer’s test. The FDA ruled that the test was “non-approvable“.

By this time, the stock had declined back into the $2’s and Nymox’s cash balance was down to just $151,000. Nymox was broke.

With its Alzheimer’s test a failure, Nymox needed a new investment thesis to boost the stock price. Nymox also desperately needed cash.

Keep in mind that Averback had already been running the company for 20 years and had so far failed to ever generate more than a few hundred thousand in total annual revenues. Even these meager revenues were simply the result of a 2000 acquisition of Serex, which marketed two diagnostic tests for detecting nicotine in urine or saliva samples. At the bottom line, the company was losing $3.5 million per year.

What was Averback supposed to do after 20 years, go out and get a real job ?!? No chance.

On the product side, Nymox soon began emphasizing a new direction for the company. Historical filings had all emphasized Nymox’s focus on Alzheimer’s, but in 2006 the company began to emphasize its new focus on BPH (enlarged prostate).

Nymox had originally been developing a whole series of compounds for Alzheimer’s, including NXD-5150, NXD-9062, NXD- 1191 and NXD-3109. But none of these ever made it into clinical trials.

Instead, Nymox began pursuing NX-1207 for enlarged prostate (BPH). NX-1207 had inexplicably been developed directly from its work on entirely unrelated the Alzhemier’s drugs, none of which showed enough promise to enter clinical trials.

To address the cash shortage, Nymox began relying more heavily on an offshore financing agreement conducted via obscure Panamanian shell company, raising over $3 million by issuing stock at discounted prices.

(Note: In the past, it has been my experience that the involvement of anonymous offshore shell companies in holdings shares has typically been for the purpose of concealing true ownership of the shares as well as concealing the offshore dumping of these shares. Such dumping often presages massive plunges in the share price. This topic merits its own discussion and is addressed in the section below. But for now, we could see that Nymox had temporarily solved its near term liquidity crisis via its new Panamanian connection.)

Despite its curious beginnings as an unrelated Alzheimer’s drug, Nymox took NX-1207 through multiple clinical trials for BPH.

Throughout 2007 and 2008, Nymox began releasing a stream of positive press releases touting strong results from Phase 2 clinical trials. Throughout 2008, the share price began to rise to over $5.00.

Based on strong Phase 2 results (according to Nymox), Nymox then took NX-1207 into Phase 3 trials. And in 2010, Nymox announced a licensing deal with Italian pharma group Recordati.

Italian drugmaker Recordati is shelling out 10 million euros [US$13 million] for access to US group Nymox Pharmaceutical’s experimental enlarged prostate drug NX-1207 in Europe, causing the latter’s shares to rocket more than 60%.

Misleading investors while secretly dumping stock

During this time, Nymox continued to put forth very aggressive and positive press releases. (A list of these is provided below). Because of the Recordati investment and the positive PR, Nymox’s share price had soared back to almost $10 by 2011.

As the stream of hyper bullish press releases continued, CEO Averback was quietly selling millions of shares without ever filing any SEC forms to disclose the sales. From SEC filings, the only way that anyone would know that Averback had sold would be to compare each annual form 20F to the previous year’s 20F and then do the math. This is further complicated by the fact that Averback has often awarded himself additional shares, which obscures the impact of his share sales.

Looking back, we can see that as of March 2011, CEO Averback owned 13.1 million shares. But by March of 2013, this number had declined to 12.2 million shares. Averback had therefore disposed of nearly a million shares when the share price was ranging from $7 to nearly $10, netting him at least $6-8 million in proceeds. As shown below, while he was selling, Nymox had put out more than a dozen bullish press releases on NX-1207.

As described in a subsequent lawsuit, in November 2013, Nymox completed enrollment for its first Phase 3 trial of NX-1207. Nymox did not make any disclosure of the results.(Note: as with most securities lawsuits, the suit was ultimately dismissed.)

Even prior to the failure, biotech journalist Adam Feuerstein from TheStreet.com was the first to highlight when these trials had already been completed as well as the fact that the results were well overdue. Investors refused to listen.

Investors had no idea, but as early as November 2013 (and certainly by May of 2014), Averback would have been fully informed that the first trial of NX-1207 had failed.

Rather than disclose this information to the public, Averback continued selling his shares of Nymox at inflated prices. Again, there was no direct SEC disclosure at the time of the share sales to US investors. Even though Averback knew that the trial had failed, he continued to have Nymox issue positive press releases on NX-1207.

By March of 2014, Averback’s share ownership was down to 11.4 million shares. CEO Averback had therefore sold over 800,000 additional shares at prices of $5-8, again netting him millions of dollars in additional personal proceeds. And again we saw numerous bullish press releases touting NX-1207 at the exact time Averback was dumping his stock.

By May 2014, Nymox’s second Phase 3 trial was completed. It was a failureand Averback would have been fully informed of this. Again, Averback refused to disclose the failure of the Phase 3 trial to investors until 6 months later, during which time he continued selling shares.

By March of 2015, Averback’s holdings were down to 10.9 million shares. He had therefore sold another 500,00 shares. But since there is no SEC disclosure of dates, we cannot prove how many of this last 500,000 shares were sold prior to disclosing the failure of the Phase 3 trials. Given that he knew of the drugs complete failure, and given his past behavior, I am assuming he sold his shares before disclosing the failure to the public.

But wait, it gets worse.

Averback wasn’t just focused on lining his own pockets. Instead, he had the company start aggressively issuing new shares to raise money that it would badly need once the trial failure became public. The shares were issued to an anonymous offshore Panamanian buyer, which would then sell them into the market. Again, no disclosure of any such sales were made at the time.

From the subsequent 20F filing (released a year later), we can see a list of the share issuances which started in December 2013. We can see that the share sales aggressively continued even after the second trial failure in May of 2014. Clearly the sale prices were (obviously) significantly above the sub-$1 levels where the stock ended up once the trails failures were disclosed.

– December 18, 2013, 48,544 common shares were issued at a price of $6.18 per share.

– January 14, 2014, 69,686 common shares were issued at a price of $5.74 per share.

– February 4, 2014, 61,533 common shares were issued at a price of $5.69 per share.

– February 28, 2014, 62,297 common shares were issued at a price of $5.62 per share.

– March 25, 2014, 65,408 common shares were issued at a price of $5.35 per share.

– April 11, 2014, 28,468 common shares were issued at a price of $5.27 per share.

– April 25, 2014, 29,487 common shares were issued at a price of $5.09 per share.

– May 7, 2014, 63,573 common shares were issued at a price of $4.72 per share.

– May 16, 2014, 59,595 common shares were issued at a price of $5.03 per share.

– May 28, 2014, 29,132 common shares were issued at a price of $5.15 per share.

– June 10, 2014, 31,062 common shares were issued at a price of $4.83 per share.

– June 23, 2014, 31,302 common shares were issued at a price of $4.79 per share.

– July 3, 2014, 21,501 common shares were issued at a price of $4.65 per share.

– July 8, 2014, 52,312 common shares were issued at a price of $4.78 per share.

– July 24, 2014, 31,672 common shares were issued at a price of $4.74 per share.

– August 5, 2014, 31,179 common shares were issued at a price of $4.81 per share.

– August 8, 2014, 60,926 common shares were issued at a price of $4.92 per share.

– August 27, 2014, 60,048 common shares were issued at a price of $5.00 per share.

– September 9, 2014, 61,703 common shares were issued at a price of $4.86 per share.

– September 15, 2014, 31,049 common shares were issued at a price of $4.83 per share.

– September 30, 2014, 37,406 common shares were issued at a price of $4.01 per share.

– October 9, 2014, 33,791 common shares were issued at a price of $4.44 per share.

– October 24, 2014, 50,040 common shares were issued at a price of $5.00 per share.

Under those drawings, Nymox received over $5 million in proceeds. The majority of these drawings occurred at a time when Averback knew with 100% certainty that the trials had failed.

As soon as the Phase 3 failures were announced, the share price plunged. But Nymox had already raised $5 million for its own use and Averback had personally pocketed at least $15 million for himself.

After pocketing the $15 million, and with the share price in tatters, Averback then announced that he would be “forfeiting” his $290,000 salary to help the company preserve cash. But he then also awarded himself 3 million new sharesupfront. This happens to be roughly the amount he had sold before disclosing the Phase 3 failures. So basically, after selling the 3 million shares for $15 million, he then got all of those shares back – for free.

Next, he then also set the company up to issue him an additional 250,000 shares per month for up to 7 years !! The justification for this massive award was that he was forgoing his $290,000 salary. But keep in mind that this would total a whopping21 million shares! Even at the distressed prices at the time of the award, the company valued these awards at $21.2 million. At current prices, they would be valued at over $60 million. This is how Averback compensated himself for forfeiting his mere $290,000 salary.

So Averback has already cashed out of at least $15 million personally. Due to the recent share price rise, his current holdings are now worth an additional $60-70 million. And with the additional shares he receives each month, he is set to receive up to $80 million more.

No bad for a company which has never even generated meaningful revenues over its 30 year history.

Included is a list of the press releases that Averback was putting out in the time that he was dumping his shares. Notice that a good number of these bullish releases occurred AFTER he was well aware that NX-1207 had failed Phase 3 trials.

As stock promotions go, Averback had turned Nymox from a complete failure into quite a success. He managed to personally pocket at least $15 millionhimself simply by selling stock at inflated prices before disclosing the drug failures. This alone was more than the total cumulative revenues of Nymox in its entire 30 year history !

But Averback wasn’t done. In fact, he was just beginning. Now that he was awarding himself millions of additional shares, he now had a massive incentive to get the share price back up.

And in fact, with nearly $100 million worth of stock at prevailing low prices, the real incentive is to simply get the VOLUME up just so he could sell more stock even at the low prices.

But there were already a series of lawsuits brewing against the company following the share price implosion.

The first thing he did was to re-domicile the company to the Bahama’s in 2015. Now he would continue to benefit from the minimal disclosure requirements, but Nymox would also be largely insulated from the legal consequences of his stock promotion.

Subsequent to changing its domicile, the next 20F noted the company no longer had any stated business purpose or any restrictions on what business it may choose to carry out:

our articles of incorporation are on file with the Acting Registrar General of the Commonwealth of The Bahamas under Corporation Number 175894 (NYSE:B). Our articles of incorporation do not include a stated purpose and do not place any restrictions on the business that the Corporation may carry on.

Nymox has institutional holdings of just 1%. The majority of outside shares appear to be simply owned in small lots by scattered retail investors. Yet somehow the vote garnered the support of 94% of these scattered shareholders.

Such a move to an offshore secrecy haven would clearly disadvantage shareholders. That Nymox could somehow garner such strong support for such a detrimental motion seems like a stretch. In fact, even getting a 94% turnout for such a retail-only stock should be nearly impossible. Locating thousands of small investors and getting them to actually vote would have been quite a challenge.

But as we will see, Nymox’s offshore Panama connection may mean that there are concentrated pockets of ownership which are not reflected in any company disclosure. This would easily explain how Nymox could obtain overwhelming approval for such a detrimental motion.

This is just my observation and opinion, it remains to be proven. In fact, this could be the single most interesting part of the Nymox promotion story, so keep this aspect in mind as we proceed.

Re-igniting the promotion from the Bahamas

As soon Averback got the company re-domiciled to the Bahamas in 2015, the immediate next step was to re-ignite the stock promotion.

What Nymox did next was to “re-evaluate” the failed Phase 3 data in what it referred to as a “prospective extension study”. It was just 8 months after the dismal failure of its two Phase 3 trials. But this simplified “new look” at the data ended now ended up pointing to an overwhelming success with NX-1207 showing dramatic benefit vs. placebo. Just 8 months earlier, NX-1207 had showed little to no benefit vs. placebo.

To be clear, this was not a new study. It was simply “data mining” using data from the existing failed Phase 3 studies. The failed data and various subsets can simply be mined and re-analyzed over and over again until a something resembling a positive result is finally obtained.

In any event, this “prospective extension study” of existing data allowed the now-Bahamian Nymox to put out an explosive press release which single handedly dove the share price up by 125%.

Additional new blinded protocol data from the same pivotal studies is being prospectively captured in order to assess long-term results in patients up to 5 years after a single injection of NX-1207 2.5 mg vs placebo,” said CEO Paul Averback at the time….

There’s no word on what the FDA’s position will be on “prospectively captured” data like this.

In that explosive press release Nymox promised that:

The Company now intends to meet with authorities and to proceed to file where possible in due course for regulatory approvals for fexapotide triflutate in various jurisdictions and territories.

The chances that the FDA allows Nymox a “do-over” on two Phase 3 trials due to after-the-fact data mining are basically zero.

Fierce Biotech had noted specifically that:

The general rule of thumb in biotech is that an unblinded Phase III failure is hard to get around. You can mount a new study or give up.

Quite obviously Nymox does not have the cash to mount a new study, which is why it simply sat and “re-analyzed” the old data until it found a subset that looked positive.

But the press release was a quick and easy way for Nymox to rally retail day traders and get the share price moving again. The ruse clearly worked due to the all retail nature of the investor base and the notable lack of analyst coverage to interpret the findings.

In reality, NX-1207 for BPH is dead. It failed both of its Phase 3 trials and no amount of after-the-fact “prospective data capture” is going to change that.

Case in point, a full year has now passed and there has not been a single update as to any progress on NX-1207 for BPH or any supposed discussion with the FDA. Not even a single new press release on BPH.

Instead, Nymox has shifted the focus to using NX-1207 for a totally different application. This time it is as an actual treatment for prostate cancer. Towards the end of 2015, Nymox began putting out preliminary early announcements of results in its Phase 2 trials for NX-1207 in treating prostate cancer.

As was the case in years past with the Phase 2 trials for BPH, the press releases were emphatically glowing about the strong prospects for NX-1207 in treating prostate cancer.

On February 9th, Nymox announced the results of the Phase 2 trial. Not surprisingly, the results were stated in a way that was overwhelmingly positive.

It was clear from the press release that “The trial commenced in February 2012” and that “The study lasted 40 months overall from the first patient randomized to the last patient 18 month endpoints.”

So you do the math. This means that Nymox already had the result of this study for 8 months before releasing the data.

This is funny because just a few days BEFORE releasing the data, Nymox conducted another financing whereby it issued $2.1 million of new shares to what it described as “long-term Nymox shareholders”.

At the time, Nymox did not disclose the names of the investors nor did it disclose the price at which the investment was made.

The point is this: Nymox already knew the results of the Phase 2 study for 8 months and it chose to sell $2.1 million of new shares at some unspecified discount to unnamed existing investors just days before releasing the positive press release. It was a true sweetheart deal. It was literally like handing the unnamed investor a pile of free money.

As expected, the share price immediately soared on 10x normal volume due to the glowing press release.

But the gains were not going to last.

Shortly after the glowing press release, independent websites focused on prostate cancer began to see the claims being made by Nymox. And this is where the latest problems began.

Website Prostate Cancer Info Link focuses exclusively on prostate cancer issues. The site is sophisticated and features detailed articles, video presentations, a daily blog and an interactive mentoring service. The site found immediate problems with Nymox’s press release.

Referencing Nymox’s Phase 2 protocol, the site noted that:

Now, as we have indicated all along, there are veryserious questionsabout whether any of these patients actually needed treatment at allat the time that they were initially entered into this study, so it is difficult to ascertain exactly what the real benefit is (or is not) from this form of treatment.

You take a group of men who show no indication that they need treatment. You treat many of them (although it is unclear from the media release or the study summary on ClinicalTrials.gov whether the patients were randomized to one or other of the three study arms or how many patients were enrolled in each of the three arms), and then you claim success without providing any data on the numbers of patients who are said not to need surgery or radiation therapy … and all this with a drug that has no side effects.

Now if these were results in men with even favorable, intermediate-risk prostate cancer (i.e., clinical stage T1c or T2a, PSA ≤ 10, a Gleason score of 3 + 4 = 7), then one might be able to see what the fuss was about, but the patients enrolled in this trial were so low risk that giving them the drug might have had nothing to do with the actual outcomesdescribed!

We should be clear that, at this time, there is no randomized Phase III clinical trial in progress or scheduled to test the effectiveness and safety of NX-1207 in prostate cancer.

In other words, these findings basically invalidated the entire glowing press release from Nymox as being nearly irrelevant. It was a sham (just like the Phase 2 BPH trials from years past).

From February 2016 until June 2016, the share price stayed range bound in the range of $2-3. There was simply no news to drive the stock.

Then on June 22nd, Nymox put out yet another explosive press release detailing the results from another “prospective study” of the failed Phase 3 BPH data.

Of all the recent press releases, this press release was the worst. It was the least substantiated and the least rigorous. Yet the language in it was by far the most extreme.

The press release simply noted that:

These results are astonishingly good

Nymox went on to point out that “The expected rate of new prostate cancer in the U.S. general male population in this age group is in the 5-20% range after 7 year”. It then stated that the observed rate for those who had received NX-1207 was just 1.3%.

This simplified high level summary is what caused the share price to soar.

But in fact, this latest press release contained pure hyperbole and virtually no data with which to back it up. First off, it seems clear that many retail traders misinterpreted the release as if it were clinical trial results, which it is not. Again, this is a simply a rehash of old data from the failed Phase 3 BPH studies from 2014. Nymox didn’t even include the most basic of information from this “prospective study”, such as what age range was used or even basic statistical information such as means, medians, p values or baseline characteristics.

And in fact, it was noted that:

All men were thoroughly evaluated to exclude any prostate cancer prior to qualifying for enrollment in the studies.

So the fact that the incidence of prostate cancer in this group was very low should have been EXPECTED, and not a surprise.

But after years of using the same playbook, such an aggressive press release from Nymox should have come as expected. Here is an example of a previous glowing Phase 2 press release on the soon-to-fail NX-1207 for BPH.

Here is the worst part:

Like the most recent press releases, it offers strong assurances and praise for NX-1207 from different expert urologists who seem to assure us of NX-1207’s promising future.

One of these doctors who has regularly touted Nyomx is Dr. Ronald Tutrone.

Dr. Tutrone is the one who was responsible for the comment stating that “These results are astonishingly good”. His credentials appear to be quite strong and the quote was very forceful. This is likely what sent the stock soaring.

Given that Averback owns millions of shares of Nymox, his own bias and self interest should be obvious to any investor.

However, Tutrone appears to be just an outside doctor who is “astonished’ by the great results for NX-1207. In the press release, there is no disclosure of stock ownership or funding by Nymox to Tutrone.

Yet for those who are willing to dig deep enough, we can see that as part of a totally separate ASCO abstract, Dr. Tutrone had been required to disclose his stock ownerships and funding relationships with various companies.

Not only has Dr. Tutrone previously disclosed that he received direct funding, but he also disclosed personally owning Nymox shares. Again, no mention of these conflicts was made in the recent aggressive press releases which sent Nymox soaring.

This disclosure was not easy to find. I am a professional researcher who specializes in biotech stocks and I knew exactly what I was looking for. Yet it still took me days to find this disclosure from Tutrone. There is simply no way that small retail investors could be expected to find such disclosure.

The Panama connection – why you should be concerned

Over the years I have learned to pay particular attention to the presence of anonymous offshore shell companies when they appear as shareholders in dubious small cap companies. Sometimes it takes a bit of extra effort to identify these entities, but it is certainly well worth the effort.

In past cases, it was the presence of these hidden offshore entities that presaged the rapid implosion of the share price. This is because these are often anonymous offshore entities who don’t disclose how much stock they own or when they are selling. Once they start dumping stock, the share price simply implodes. Bystander investors are left wondering what happened. In most cases they will never know.

Note that there is no way to prove this until well after the fact, so for now it remains just my opinion based on past experience.

I saw this to dramatic effect when I exposed fraudulent Forcefield Energy , which had been trading at around $7.50. Following my article, that stock imploded by 60% in 3 days before being halted. When it reopened, it immediately traded down to just pennies. The reason why was clearly the dumping of shares held by anonymous offshore entities in Belize. More details are provided on this below.

With Nymox, the company disclosed the involvement of an offshore Panamanian shell company named Lorros-Greyse Investments to provide financing to the financially strapped company. The earliest reference to Lorros-Greyse appears in 2003, which is the inception of Nymox’s agreement with Lorros.

We can see from the formation documents that Lorros-Greyse was actually formed within just days of the beginning of this arrangement with Nymox. We can also see that over the past 13 years there are no other references online or in SEC documents. With Lorros-Greyse, there has been no other activity and no involvement with any other company other than Nymox. EVER.

The point is that Lorros-Greyse is simply an anonymous offshore sell company which was set up specifically to run the Nymox transactions and for no other purpose. It has been my observation that such anonymous shell companies are used to hide three things: the identity of the ultimate share holder, the size of their position, and the actual selling activity.

As an offshore entity, all sales to Lorros-Greyse were made pursuant to AN EXEMPTION FROM SEC REGISTRATION. Likewise, any sales by Lorros-Greyse would be unregistered offshore sales as well. They would be invisible to US shareholders, even though they would certainly impact the share price of Nymox stock in the marketplace.

Lorros-Greyse has no purpose other than acquiring and disposing of shares in Nymox. There has never been any other activity or reference to Lorros-Greyse. But by tracking down the nominee directors of Lorros-Greyse we can identify their activities in other similar companies.

It should come as no surprise that the other companies which w can tie to Lorros-Greyse have imploded to the pennies.

Note that the named directors are nominee directors only. They are NOT the beneficial owners who control the stock. The real owners are hidden.

For example, Viewpoint Investment Corp is another anonymous offshore Panamanian shell company. We can see from its formation documents that it has nearly identical directors as Lorros-Greyse.

Like Lorros-Greyse, Viewpoint appears to have been solely formed for the purpose of acquiring and disposing of millions of shares of a single company called 3Power Energy (OTCPK:PSPW). The shares would be acquired at a deep discount and then sold offshore using exemptions form US securities laws. At the time of its reverse merger, 3Power was trading at $2.48. Since that time it has collapsed to just 8 cents. Despite owning nearly 20 million shares, Viewpoint never disclosed owning these shares in any SEC filings. It also never disclosed when it sold (dumped) these shares. Anyone still holding onto shares of 3Power is simply left wondering what the heck happened to cause such an implosion.

Dianeth M. De Ospino is listed as a director of both Lorros and Viewpoint. She is also a director for another Panamanian entity called Opunosa Investment, whose sole purpose was to acquire and dispose of millions of shares in a company called World Gaming. Opunosa has not disclosed any sales of shares in World Gaming, however the share price has now imploded to just factions of one penny. Again, uninformed investors in World Gaming get to simply wonder what happened.

THE POINT IS THIS:

Lorros-Greyse is Viewpoint and is also Opunosa. It is all the same exact thing. They even use the same Panamanian law firm, Morgan & Morgan.

Morgan & Morgan received a “dishonorable mention” from The Economist in an article entitled “Who’s Next ?”. The focus of the article was on “incorporation mills” in Panama. Such firms received heavy attention this year upon release of “The Panama Papers” which detailed how many international politicians were using Panamanian entities to hide ill gotten assets and conduct illegal activities.

The Economist noted:

other incorporation mills face more scrutiny too, among them Panama’s other big law firms, such as Morgan & Morgan, and OIL, part of Hong-Kong-based Vistra, which caters primarily to Chinese customers. Like Mossack, these are wholesalers. They sell shell companies in blocks to law firms and banks, which sell them on to the end client, sometimes via other retailers.

A while back I exposed problems at Forcefield Energy . Forcefield plunged by more than 30% on the day of my article and management quickly issued a forceful response against me. Forcefield claimed that it had requested that I be investigated by regulators and stated that:

“We are not going to stand by and allow our Company, officers and directors, employees and shareholders to continue to suffer through what appears to be an orchestrated short selling attack based on misinformation”.

In putting out this press release, management was simply telling the latest in a string of lies that it had told to shareholders.

Forcefield promised to give shareholders a full business update on the company on the following Monday. In the meantime, the share price continued to plunge on massive volume and was quickly down by 60%. But when Monday rolled around, the only update the company could give was that the Chairman of Forcefield had been arrested by the FBI at Miami International Airport, as he was trying to flee the country, following my article.

Again, this all happened within 3 days of my article exposing the fraud at ForceField. For those who have time, I recommended re-reading that article, as it provides some good hints on how to spot impending frauds.

An early tipoff that Forcefield likely had major problems was the existence of numerous transactions and arrangements in offshore havens such as Panama, Belize and Costa Rica.

Just like Nymox, Forcefield appeared to have institutional investment of just 1% of outstanding shares. It appeared that 99% of the stock was spread out in the hands of retail investors. But we can see from the subsequent implosion that this was not the case at all.

According to the Justice Department complaint:

St. Julien [The Chairman] did not disclose his ownership and control of the shares purchased through nominees and used offshore banks, including in Belize, to pay the nominees to conceal his ownership and control. St. Julien coordinated the purchases by telephone and text messages…. Through his scheme, St. Julien and his co-conspirators deceived the investing public by creating the appearance of genuine trading volume and interest in ForceField’s stock

The FBI ended up indicting nine individuals in a $131 million fraud scheme which involved payoffs using brown bags filled with cash as well as disposable cell phones and content-expiring messaging applications in an attempt to avoid tracing,

They took a company with essentially no business operations and little revenue and deceived the market and their clients into believing it was worth hundreds of millions of dollars through a dizzying round of unauthorized trades and deceptive promotions.

(Hint: In my opinion, this sounds quite a bit like Nymox).

Within just a few trading days of my article, Forcefield had collapsed by nearly 100%. The only explanation for this is that the ownership of Forcefield stock was far more concentrated than the supposed “1% institutional interest” would indicate. When these undisclosed holders chose to sell, they dumped massive amounts of stock, crushing the share price. These large, undisclosed, offshore holders were invisible to the rest of us. But they knew more than anyone that the company had no cash and no business prospects. Even after the share price had plunged by 50%, these holders were still willing to sell at any price, because they knew that the stock was ultimately worthless.

Based on my experience with Forcefield, I think I have every reason to have similar concerns about Nymox and its use of anonymous offshore Panamanian entities to conduct its financings. Given that the transactions are unregistered, we have no idea who is behind Lorros, how many shares they may still hold, when they are selling or how much.

The recent “sweetheart” financing deal in February to another anonymous investor only adds to my concern.

A history of using troubled auditors favored by pump and dumps and stock promotions

Many years ago, Nymox had all the appearances of a legitimate company. It had a single drug in two Phase 3 trials, it had accumulated a decent cash balance via its licensing deal with Recordati and it was audited by Big 4 auditor KPMG.

But as soon as the truth came out regarding the failed Phase 3 trials of NX-1207, everything changed. Fast.

We already saw that the share price imploded by more than 80% to just pennies. Almost immediately thereafter, two long term board members (Roger Guy and Jack Gemmell) resigned.

The cash had long since run out. Nymox was down to around $600,000 is cash and had a working capital deficit of $580,000. Over the prior year it had burned over $5 million in cash.

KPMG then found material weaknesses in Nymox’s internal controls. As of 2016, these material weaknesses have still not been remedied.

Thayer O’Neal and the revolving door of troubled auditors

Nymox was then forced to find a new auditor. Nymox initially settled with little known Cutler & Co. But following Cutler’s deregistering with the PCAOB, Nymox ended up with the audit firm of Thayer O’Neal.

Thayer O’Neal is basically an auditor for failed penny stock promotions. Both John Thayer and Thomas “Mickey” O’Neal had been partners at a firm called LL Bradford. LL Bradford had just merged with another little deeply troubled auditor called RBSM. The PCAOB had conducted a detailed inspection of RBSM in 2014, finding numerous deep auditing deficiencies. That report was not released until 2015, at which time the troubled RBSM simply merged with troubled LL Bradford.

LL Bradford itself was then shut down 7 months ago when the PCAOB censured the firm and revoked itsregistration, stating:

the Firm [LL Bradford] repeatedly violated PCAOB rules, auditing standards, and quality control standards and, in connection with several of those audits, also violated Section 10A(g) and Section 10A(j) of the Securities Exchange Act of 1934 (“Exchange Act”) and Exchange Act Rule 10A-2 concerning auditor independence.

These are very serious violations and as a result, LL Bradford was shut down completely.

Partners Thayer and O’Neal then simply started a new firm, changed the name and picked up LL Bradford/RBSM’s troubled former clients. As a result, the “new firm” quickly assembled a roster of failed penny stock promotions.

From his LinkedIn page, partner Thomas “Mickey” O’Neal clearly describes his “new” firm as just a “spin off” of the defunct LL Bradford and RBSM.

In other words, this is just a revolving door of faulty audit practices. When the PCAOB shuts one down, the partners just put a new name on the door and keep performing the same poor audits for the same troubled clients.

Aside from Nymox, this is who the “new firm” Thayer O’Neal audits. It is simply a collection of failed stock promotions which were previously audited by LL Bradford / RBSM and which trade for just pennies.

Nymox has basically picked an auditor who’s past history shows that it is among the worst of the worst. The partners and their clients have a history of massive audit deficiencies and the predecessors were simply shut down by the PCAOB.

Thayer O’Neal simply adopted a new name and continued to audit the same companies.

This existing client list shows that Thayer O’Neal is the auditor of choice for failed penny stock promotions which trade for just a few cents and with no meaningful market value. Nymox appears to be the ONLY EXCEPTION to this pattern – for now.

Nymox’s legal counsel charged with running other stock frauds

From the recent equity prospectus in February 2016, we can see that Nymox is being represented by Zouvas & Associates LLP.

We are being represented by Zouvas & Associates LLP; the validity of the securities being offered by this prospectus and legal matters relating to applicable laws will be passed upon for us by Zouvas & Associates LLP.

Zouvas’ name also appears in previous Nymox SEC filings.

Anyone who is familiar with this name will immediately start hitting the “sell” button before reading any further.

(For those who wish to understand the mechanics of offshore stock promotion, I highly recommend reading that article.)

Nymox’s attorney Zouvas separated from Carrillo to found his own firm, which also focused on stock promotions. His brother Mark is an accountant who often runs the books. Up until the recent SEC charges, it had been a great recipe for stock promotion success.

Examples include the now bankrupt Reostar Energy. The ensuing lawsuitnoted that:

An alleged under-the-table deal between former CEO Mark Zouvas and several investors to sell the company’s credit line at a low ball price was approved after the board of directors was misled… the deal designed to skim millions of dollars to Zouvas.

Other past Zouvas promotions include Bold Energy (Pending:BOLD) which eventually became the stock Lot78 (OTCPK:LOTE). Nymox’s attorney Luke Zouvas acted as the attorney in the deal.

Similar to Nymox, Lot78 was a low priced penny stock which soared to over $4.00 due to stock promotion and bullish press releases. Just like Nymox, Lot78 had minimal revenues, was largely out of cash and had virtually no institutional investment. Yet the share price rose on retail hype alone.

An article on Seeking Alpha came out, exposing the promotion, entitled:

USA Graphite Inc. has been in the top ladder of OTC Markets activity statistics for the last couple of weeks. Just as we speak, the company has already turned over more than $1.6 million worth of shares and this is just the first half of today’s trading session. At the same time USGT stock has hit $0.87 per share which is nearly double its value from one month ago.

Mix 1 Life, which makes nutritional shakes now carried in the health-foods sections of some large Arizona supermarkets, recently embarked on a local TV ad campaign. The Scottsdale company still hasn’t posted a profit, but recent sales have ramped up. Mix 1 Life is worth $30 million, at a recent share price of $2.30.

After shares traded for less than $1.50 on Wednesday, they ended the week at more than $6. There was no news to justify the price soaring.

Nymox’s banker of choice – Chardan Capital Markets

History has shown us that when Chardan says “BUY” the wisest move is to quickly hit “SELL“.

In February, Nymox filed a 424B5 prospectus with the SEC hoping to raise up to $12 million by issuing new shares. This is the most recent document naming Zouvas at Nymox’s attorney. It also named Chardan Capital Markets as Nymox’s banker.

The timing of the prospectus also happened to coincide with Nymox issuing a new bullish press release. Nymox clearly wanted to be prepared to issue more stock if the share price soared.

Chardan was originally founded by Dr. Richard Propper, later getting his son Kerry Proper involved.

Chardan and its founders have a very long, long list of securities law violations going back decades and yet somehow the firm stays in business. Even a cursory Google search reveals multiple SEC and FINRA disclosure events / violations. Here is one recent detailed example on market manipulation of 4 US based small cap companies.

In the 1990’s, Richard Propper resigned as the managing general partner at Montgomery Medical Ventures, a venture-capital firm controlled by Montgomery Securities, amid reports that he inadvertently disclosed to a family member inside information about a Montgomery-related transaction (SEC investigation).

It was at about this time that the Proppers and their Chardan Capital discovered the gold mine that was Chinese reverse mergers and SPACs (Special Purpose Acquisition Cos).

The implosion of Chinese reverse merger frauds is where Chardan became truly egregious. But this is where the firm also ended up making a fortune.

GeoInvesting (AKA The GeoTeam), highlighted no less than 17 different examples of Chardan Chinese reverse mergers / SPACs, the majority of which completely imploded following exposure of or allegations of fraud.

To highlight just a few examples:

Chardan formed the SPAC that housed Chinese A Power, which was then halted and delisted. It no longer trades.

Chardan formed the SPAC which also housed CABL, which voluntarily delisted from the NASDAQ.

Chardan was also involved in the $30 million capital raise for Liwa International (NASDAQ:LIWA) which imploded due to exposed fraud.

Chardan received substantial negative attention for an imploded fraud called Huiheng Medical, which was supposedly involved in treating brain cancer.

This attention went mainstream against Chardan and the Proppers in a USA Today article.

The USA today article details obvious and egregious supposed “oversights” by Chardan and the Proppers. A reporter who traveled to China revealed that Huiheng was in fact just an empty building with a tiny parking lot and little activity going on.

The USA today article also details numerous additional imploded frauds where Chardan and the Proppers were involved, making millions as investors lost everything.

Eventually it became clear that the market was no longer dumb enough to buy Chinese reverse merger frauds. But the Proppers still had an unused empty shell company which they wanted to monetize.

The empty shell had originally been intended for another China target and was (at the time) aptly named “Chardan 2008 China Acquisition Corp“.

By 2010, Chinese reverse mergers were imploding in a wave of outright frauds and Chardan and the Proppers were already getting heat for it. Anything with “China” in the name was toxic and no longer marketable to naïve investors. But Chardan and the Proppers had clearly spent millions of dollars setting up this empty shell acquisition company.

Rather than let it go to waste, Chardan simply changed the name and purpose of the shell and had it buy a US based law which specialized in processing mortgage foreclosures. Such foreclosures were booming in the wake of the 2008/2009 financial crisis in the US.

As with the USA Today article, the NY Times details the lengthy history of regulatory violations from Proppers.

Here is the summary:

Chardan had its defunct “China” SPAC purchase the US based law firm of David J. Stern, which focused on processing housing foreclosures. As a result, the private company then became publicly tradable and was named “DJSP Enterprises”

Aside from making millions in fees, as the owner of the SPAC, Chardan retained a significant amount of ownership in the newly public company, receiving millions of shares for just pennies a piece. And then Dr. Propper was paid additional fees to act as a “consultant” to the company.

Shares of the company quickly soared to as high as $14 and Mr. Stern ended up cashing out a whopping $60 million.

But then the Florida Attorney General’s Office began investigating DSJP for falsifying documents to speed up foreclosures. The firm quickly lost its biggest clients. Its executives quit and the firm quickly fired 80% of its staff. In addition to the issues with regulators, the firm faced new lawsuits from both investors and employees.

DJSP now trades for just 13 cents.

Even with a US target, it turns out that Chardan’s renamed China SPAC ended up no better off than the previous generations of reverse merger frauds pursued in China.

The typical Chardan deal is heavily followed by retail investors who simply buy into the hype of a sexy story and a few bullish press releases. But when Chardan helps these companies raise money, it does need to get institutions to pony up a millions of dollars at a time.

QUESTION: If Chardan’s history of regulatory violations and stock implosions is so widely documented and well known, then how have they gotten new investors to buy into their deals ?

ANSWER: Give away FREE MONEY !

Here is how the technique works.

First, give some “friendly” investors a heads up that a company needs to raise money.

Second, those companies get SHORT the shares of the subject company, in advance of the financing deal.

Third, one or more banks announces that the company wishes to raise money at a discount. The share price falls.

Fourth, the “friendly” investor then buys the new shares at a considerable discount, covering its short position at a nice profit.

This is a great trade for all of the inside players involved. Everybody wins.

The bank involved makes a fat fee for running the offering.

The “friendly” investor makes a tidy profit with literally zero risk.

The company raises a few million dollars and then puts out a press release which leads smaller (naïve) investors to believe that some institution has enough confidence in the company to commit millions in capital to it.

The only ones who get suckered are the retail investors. Because in reality, this investor merely covered their short position and in no way wants to commit any capital whatsoever to this company or this deal. They know it is likely going down, not up.

No, this is not a hypothetical. And no, I am not making this up.

Here are the SEC charges which describe that exact sequence of events when Chardan was helping AutoChina raise money. Investor Charles Langston, who controlled CRL Management, LLC and Guarantee Reinsurance, LTD, got the heads up from Chardan and quickly began selling shares at $41.75. That very same afternoon, the deal was announced and Langston was able to cover his short at $35, making a near instant and riskless 17% profit.

Chardan’s defense to this is that it had sent Mr. Langston a “confidentiality” agreement and told him not to trade on it.

However, we can see from the SEC case that this was actually the 4th time that Mr. Langston has performed the exact same trade. Each time, he would short in advance and cover on the deal.

It becomes quite clear why someone like Mr. Langston would not want to hold Chardan’s AutoChina.

By now, the mechanics of the fraud should start to sound familiar. This includes the use of offshore brokers and undisclosed holdings. The parties would make fraudulent trades between their own accounts to generate the appearance of legitimate trading volume and interest in the stock.

For those who wish to read more about Chardan implosions, here is a very partial list. Note that these are all recent deals on US listed small caps.

Northwest Bio

Chardan recently announced that it would be helping Northwest Bio raise a few million dollars. I had previously exposed a well orchestrated pump on Northwest Bio entitled:

This promotion had driven the worthless stock up to $7.50. Like the others, it was supposedly a promising biotech with a new treatment for cancer. (sound familiar?) The stock has since imploded to just 43 cents.

XXII was exposed by the GeoTeam as a stock promotion, which included details of insider’s past involvement in stock manipulation and excessive compensation of insiders bleeding the company dry.

Geo details Chardan’s lengthy history in financing the company, including the fact that it has received shares in XXII as compensation. Chardan had been aggressively touting the company, releasing a research report with a $9.00 target.

XXII has since imploded to just $1.00.

So again, Nymox recently filed a prospectus using Chardan as its banker and Zouvas as its lawyer. Nymox is again looking to sell millions of shares, following its hyper bullish (but unsubstantiated) press releases.

You do the math. This history of these parties should speak for themselves in terms of where the share price is headed.

James Robinson is a big time Hollywood film producer He is the CEO and co-founder of Morgan Creek productions, which has produced dozens of well known hit movies, including the Ace Ventura Series, Young Guns, The Last of the Mohicans, Robin Hood: Prince of Thieves, The Major League series, Get Carter, Heist, and many others.

Robinson is now 81 years old and his net worth has been estimated at over half a billion dollars.

But please keep in mind that he has never shown any experience in biotech or in investing in small cap stocks.

Jim has been a long-term supporter of the Company in the past and this is great news for our shareholders

It is unclear what Nymox meant by “long-term supporter”. But in any event, we can see that Robinsons first SEC filing disclosing ownership of Nymox did not occur until 2 weeks AFTER that press release.

A that time, Robinson disclosed owning 2.1 million shares of Nymox.

Since that time, the 81 year old film director has continued to acquire small amounts of stock every few weeks or months. This is never more than a few thousand shares at a time, amounting to typically $10,000 or $20,000.

Yet each time he makes another small purchase, the news wires flag another “insider purchase by a director”. This (along with the bullish press releases from Nymox) is enough to lure in a few more retail investors and helps to keep the stock afloat.

I have already demonstrated above that so far EVERYONE with any involvement in Nymox has a lengthy history of imploded stock promotions, regulatory violations and / or outright fraud. This includes management at Nymox, their auditor, their legal counsel and their banker.

So far, I don’t believe that this is the case with Robinson. He has far too much money and far too big of a reputation to be caught up in a penny stock promotion to make just a few million dollars.

The reality is that I don’t know what attracted the 81 year old film producer to Nymox in the first place. But again, Robinson has never demonstrated any expertise with biotech or with small cap stocks.

What I do know is that I have seen this exact “movie” before and it always ends badly.

Robinson will lose a few million dollars on his investment in Nymox. He can certainly afford this small loss. In fact, with such a substantial net worth, I have no doubt that this will just be a tax write off at the end of the year against various other capital gains he may have. The financial impact of this will not be a big deal for Robinson.

A much bigger deal will be the damage to his reputation when his involvement hits the financial press and the Hollywood tabloids, which I am quite certain it will.

Here is what you need to know about the purchases by Robinson:

Recruiting a prestigious outsider is a standard play out of the penny stock promotion handbook I have seen it many times before and I will (of course) provide multiple examples.

In order to gain some credibility with retail investors, penny stock promotions try very hard to lure in any outside investor, manager or director who has some combination of wealth, fame or status.

As a board member, they frequently attract older retired executives who simply want to stay relevant and be “in the game” rather than being perceived by their peers as having been “put out to pasture”.

Despite the hype surrounding their appointments, these board members are not really required to know much about the underlying company and their involvement is limited to typically 8-10 days per year.

Again, I have seen this same phenomenon over and over again where wealthy, older executives are lured into a small cap stock promotion. They then lose their investment and their reputations when the promotion implodes.

There are many examples. I will start with four that come to the top of my mind.

In 2015, a tiny microcap called DS Healthcare had minimal revenues, going concern warnings from a dubious auditor and multiple weaknesses in internal controls. The company was a blatant stock promotion with obvious problems and a market cap of around $50 million.

In April 2015, the company managed to recruit 72 year old Manny Gonzalezas its Chief Commercial Officer. In the press release, DS Healthcare noted that:

In his role at Procter & Gamble, Mr. Gonzalez was responsible for managing an organization with $30 billion in revenue including the entire North American merchandiser sales force of over 3,000 sales representatives for all Procter & Gamble product categories, including the company’s extensive personal care products portfolio….. In addition to his 23 years of experience at Procter & Gamble, Mr. Gonzalez is the current Chairman of Center for Leadership, Florida International University (2013-current). He has served as Chairman of the Board Services Committee for Zoological Society of Florida, Board of Directors of Procter & Gamble Good Government Fund (GGF-PAC), and Vice-Chairman of Industry Trade Advisory Committee for Consumer Goods (ITAC 4) at U.S. Department of Commerce and ITA.

There is no doubt that Gonzalez is an experienced industry veteran in consumer products and a major big shot. This was tremendous news and appeared to completely validate the tiny microcap company.

Not surprisingly, the stock quickly doubled on the news.

Yet not long after his appointment, a scathing report from Bleecker Street Research highlighted deep problems at this transparent stock promotion, including:

– The company had virtually no revenues and was out of cash

– The stock had soared on a series of misleading press releases

– A going concern warning and a dicey auditor

– Ineffective internal controls

– Past due SEC filings (including 10K and 10Q)

– Management almost entirely run by one individual, founder and CEO Daniel Khesin

Not surprisingly, the disturbing revelations from Bleecker resulted in an immediate plunge in the share price of DS Healthcare. It quickly ended up plunging by more than 50%, and by now it has fallen by around 80% from its pre Bleecker levels. DS now trades for around 60 cents, but there is so little volume that it is nearly impossible for anyone (including Gonzalez) to sell much stock.

As with the involvement of Robinson in Nymox, it is unclear how an experienced industry veteran could be lured into such a dubious stock promotion. But as we will continue to see, this does happen all the time.

In June of 2016, microcap Chromadex Corp announced the appointment of 77 year old William D. Smithburg to its board of directors. Chromdex is purportedly in the “supplements” business and Smithburg had previously been Chairman of Quaker Oats, following a multi decade career there.

The 77 year old Smithburg had previously been President and CEO of Quaker Oats, as well as serving on the board of directors for several well known publicly listed US giants including: Abbott Labs, Northern Trust and Corning, among others.

In addition, it was noted that Smithburg had disclosed owning 640,000 shares of Chromadex, all made in open market purchases. These were valued at nearly $4 million at the time.

Once again, an exposé report from Bleecker street revealed the existence of significant issues at Chromadex. The report was nearly 40 pages long. I printed a hard copy.

Bleecker had stated that:

Just weeks earlier, a key backer of Chromadex had just been publicly named specifically in a SEC plea agreement for another imploded fraud

Just a few weeks earlier, a key Chromadex director had just been indicted in a massive securities fraud case, but Chromadex had swept the news under the rug

Past Chromadex key investors had gone to jail for fraud, including for dumping undisclosed share holdings

Chromadex backers had a long history of involvement in similar microcaps which ended up imploding to the pennies.

Following the Bleecker report, the share price quickly plunged by as much as 50% on that single day.

And again, director candidates are typically expected to put in no more than 8-10 days per year in their companies, such that it is unlikely that the veteran Mr. Smithburg had any idea about the concerning allegations about Chromadex.

The 77 year old Mr. Smithburg quickly recognized that he was in over his head. He wanted nothing to do with such controversy.

The point (so far) is this: Despite the fact that he was an experienced industry veteran and had substantial board experience with very legitimate large cap stocks, Mr. Smithburg had no idea what he was getting into when he entered the world of heavily promoted microcaps. He made a very smart move by simply resigning as soon as even the hint of fraud and the involvement of fraudsters appeared.

And then it gets even more interesting.

About a week after the article was published, Bleecker took the unusual step of removing the article from publication. I am still unclear as to what behind-the-scenes events led to this outcome.

In fact, this simply strengthens the case the Mr. Smithburg was simply not well informed at all about Chromadex.

Had Mr. Smithburg known of problems at Chromadex, he would never have joined the board. And yet had he known about some perceived problems in the Bleecker article he would seemingly not have resigned.

The point is simply that the 77 year old Mr. Smithburg was appointed to the board and invested millions of dollars into the stock without really having enough information at all. He was ill informed when he joined the company and he was arguably ill informed when he resigned.

Because he had so little information, resigning is certainly the smartest move for him to make.

Example #3 – China Biotics (formerly CHBT) and Richard Azar

Back in 2011, I was intimately involved in exposing a Chinese reverse merger fraud at China Biotics. I had been living in China and I had been able to gain access to the company’s factories, proving that there were no operations and virtually no employees. It was an egregious empty shell fraud.

I was not alone in my fraud conclusions. There were at least a dozen other reports from well known short sellers providing truly conclusive evidence that China Biotics had no operations and was a total fraud. Yet the market cap still hovered at around $200 million.

At the time, Chinese reverse mergers were imploding due to fraud on a weekly basis. Literally hundreds of these former highfliers went straight to zero when their auditors resigned after finding fraud.

China Biotics was due to be audited in just a few weeks, when a little known investor named Richard Azar suddenly disclosed taking a massive 20% stake in the company, nearly $40 million worth of stock. Azar had been described as an accomplished investor who had taken large positions in other related industries. His net worth had been estimated in the hundreds of millions of dollars. Notably, he had never demonstrated any experience in Chinese micro cap investing.

Azar has been actively investing since he was 17. His father loaned him $100,000 at the time, and Azar paid his father back two years later by buying Berkshire and making currency trades. Azar retains a significant stake in Berkshire stock today.

Educated in Canada and the U.S., Azar was turned down at Harvard Business School, but said it was a blessing in disguise, as he used those years for intensive study of books about Buffett and value investing and continued business success.

He kept right on piling up stunning returns, vaulting him into the top ranks of businessmen in Trinidad. If Azar lived in America, he would be one of the wealthiest Americans for his age and could be in Fortune’s list of the 40 wealthiest people under 40.

As a result of the huge investment from Azar (which was shown in public SEC filings), China Biotics quickly surged by as much as 40%. After all, a sophisticated international investor like this wouldn’t take such a massive positon in such a controversial stock unless he “knew something” through deep due diligence.

As with the Nymox purchases by Robinson, Mr. Azar’s purchases were revealed in a string of continued SEC filings where various amounts continued to be purchased over time at various prices.

Retail investors also piled into the stock, trying to ride on the coattails of Mr. Azar.

Yet the fraud allegations against China Biotics were very public. Anyone using Google could see numerous articles and allegations.

And then just few weeks after the purchases by Mr. Azar, it was announced that China Biotics auditor had resigned due to egregious findings of outright fraud and that it would then simply voluntarily deslist its stock to the pink sheets. China Biotics no longer trades.

Subsequent SEC filings revealed that Mr. Azar continued to own over 4 million shares of China Biotics. His $40 million investment simply went to zero.

Like China Biotics, China Medical Technologies was a fraud. And just like China Biotics, China Medical managed to lure in an international “high net worth” investor who would quickly lose tens of millions of dollars.

At one time, device maker China Medical Technologies was trading at around $4-5. It was publicly exposed in a fraud report by Glaucus research. The stock plunged. The company then defaulted on its debt and its auditor resigned. The stock was truly worthless and quickly plunged to below $1.00.

At this time, despite the obvious terminal situation, a wealthy New York wine merchant by the name of Peter Deutsche began buying massive amounts of China Med stock. Literally tens of millions of dollars.

Like Robinson at Nymox, the Deutsche family was extremely successful in a certain industry, namely importing wine. They created a wine empire worth hundreds of millions of dollars.

But (like Robinson at Nymox), they clearly had no expertise in microcap stocks or specifically with medical devices.

Again, China Medical had been exposed as a fraud, its auditor had resigned and the company had defaulted on debts worth hundreds of millions. Yet retail investors chose to ignore all of these data points and focus on a single data point: that a wealthy New York wine merchant was buying the stock.

After all, such a “high net worth” investor who had been such a success elsewhere wouldn’t dive in and make such a huge investment without an information advantage.

The huge purchases by Mr. Deutsche attracted plenty of attention from retail traders and the stock price quickly soared by 200-300%.

Finally, the SEC stepped in and halted the stock. When it resumed trading, it immediately plunged. It has since been entirely delisted and no longer trades. The Deutsches lost effectively their entire investment, as did the retail punters who went along for the ride.

The Deutsches have since blamed their broker, Fidelity, for the tens of millions in losses and are now involved in a lengthy and detailed (and very embarrassingly public) court battle.

Unfortunately for the Deutsches, the whole story has been publicly aired by Bloomberg and other media outlets in excruciating detail.

Behind the purchases of James Robinson

Here is how I see it:

In each of the examples above, we should be reminded of the old saying by poker players:

Whenever you walk up to the poker table, you should always try to spot the sucker. If you can’t spot the sucker, chances are….it’s YOU.

In each case, the individuals above were smart and wealthy. They were also very experienced in their own respective industries. But when they sat down to play the new game, they were the sucker and they were quickly taken by those with experience.

With Nymox, effectively, a few seasoned players sat down for a friendly game of poker. But they game wasn’t “Texas hold ’em”, it was “microcap stock promotion”.

For a time, the key players were as follows:

Nymox CEO, Paul Averback – Experienced stock promoter who reaped tens of millions from a company which is out of cash and which has failed to sell products for 30 years.

Auditor, Thayer O’Neal – Penny stock “auditor” who was formed by simply renaming itself as a spinoff from LL Bradford which had been shut down by the PCAOB. Very experienced with the books of tiny reverse mergers, which have imploded to just pennies.

Legal Counsel, Luke Zouvas – Experienced attorney for dozens of imploded micro cap stock promotions, which also imploded to the pennies. Recently charged by the SEC with securities fraud for an imploded penny stock promotion fraud.

And then at some point, up to this poker game walks an extremely wealthy 81 year old film producer. Unlike the others, the film producer has ZERO EXPERIENCE in biotech or small cap stocks.

The four experienced players are thrilled (absolutely THRILLED) to welcome the wealthy 81 year old film producer (and his money) to the poker game. Not only is he putting millions of his own money into the stock, but the attention is attracting small retail investors who also put money into the stock. Nymox share price (and VOLUME) rises accordingly.

Again, attracting wealthy and successful “board members” is a standard play out of the stock promotion hand book. It happens all the time. Despite the hype from the press releases and the monetary investments, these individuals often know far too little about the companies they are getting involved with. Even though their investments appear large, they are in fact small relative to their total net worth. The time commitment of a board member is often just a few days a year, such that it does not justify doing a “forensic level” of research on the company or its partners.

Not only do such individuals quickly lose millions of dollars, but they also endure very public embarrassment, especially due to the association with people who have ties to fraud.

Conclusion

In the past, I have written about many biotech stocks which were highly problematic, but I refrain from predicting that they will go to “zero”. Many of these biotechs quickly imploded by 80% or more. Nymox is even worse, because it is truly a zero and is likely to go there quite fast.

Nymox is an offshore stock promotion with reported institutional interest of just 1% and no research coverage. Yet the history of using a pre-constructed anonymous Panamanian offshore financing vehicle to issue piles of unregistered stock makes me believe that there are undisclosed pockets of offshore ownership. In the case of Forcefield Energy, this is what ultimately caused the stock to implode to the pennies (99%) within just a few trading days of my article exposing it. The people who held the stock offshore knew without question that it was a fraud and a zero. As a result, they continued to dump millions of shares even when the stock was below 50 cents.

Nymox clearly had in its possession the full data that NX-1207 had failed Phase 3 clinical trials, yet it continued for 6-12 months to put out bullish press releases while management continued to secretly dump millions worth of stock without making timely SEC disclosures.

After the implosion, Nymox re-domiciled to the Bahamas and restarted the promotion with a new string of misleading press releases. The stock price has subsequently soared by as much as 10x.

The press releases are easily debunked and the doctor behind the most recent press release did not disclose direct funding from Nymox or ownership of shares.

Following 30 years of various failures, Nymox is now down to just $800,000 of cash and continues to generate no material revenues. The company has a “going concern” warning and its internal controls have been deemed ineffective for over 2 years now.

Nymox’s legal counsel was just charged by the SEC for securities fraud and has a long history with imploded penny stock promotions, very similar to Nymox. At one time, these stocks (like Nymox) had soared on promotion, they now trade for just pennies.

Nymox’s auditor Thayer O’Neal is simply a renamed “spin off” from LL Bradford which was shut down by the PCAOB for gross audit deficiencies. Thayer has since just picked up all of the old LL Bradford clients, which happen to also be imploded penny stock promotions that trade for just a few cents.

Nymox’s banker has a decades long history of run ins with regulators for stock manipulation as well as a very visible history of financing fraudulent companies which quickly go to zero.

Recent share purchases by James Robinson have boosted the share price and attracted small retail investors into the stock.

Mr. Robinson is an 81 year old film director who is based in California. He is very wealthy but has no experience in biotech or small cap stocks. Nymox is based in the Bahamas.

Targeting such individuals by offering easy board appointments is a truly standard tactic of many stock promotions which I have exposed in the past. These board positions typically require just a few days per year and do not involve in depth background research by the new board member.

Disclosure: I am/we are short NYMX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of healthcare companies including medical device, pharmaceutical, genomics and biotech companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in NYMX and during the past 12 months has shared his fundamental and/or technical research with investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied

In a best case, BRS delivers very outsized losses going forward. In a worst case, BRS violates debt covenants and faces default.

Recent statements by management are blatantly at odds with previous SEC disclosure. SEC inquiries into the use of offshore tax havens may have a separate impact on the stock.

This report is comprised of 3 sections.

SECTION I details a string of recent critical problems hitting Bristow just ahead of earnings. Numerous issues do not appear to have been disseminated to or digested by the investing public at all. The fact is that Bristow has massive unhedged currency exposures to both the British Pound (down by nearly 15% in 3 weeks) and the Nigerian Naira (down by 40% in 3 weeks). However, numerous other issues are detailed, including concerns over UK Search and Rescue. In just 9 trading days, Bristow is set to host its quarterly earnings call and will be forced to disclose these impacts. I expect a nearer term decline of 40-50% on the stock (share price down to around $6-8). However, as with its recently bankrupted competitors, the prospects for an actual default within 9-12 months remains moderate to high (share price to below $1). This is precisely what we have seen with Erickson Air Crane (NASDAQ:EAC), CHC (HELIQ) and other helicopter operators, which imploded by 99% as their credit situations unraveled.

SECTION II primarily focuses on a line of SEC inquiries into Bristow. In early 2015, (when Bristow was still profitable and supposed to pay taxes) the SEC began inquiring into certain offshore tax strategies being used by Bristow. Bristow first attempted to give limited, partial responses, but the SEC persisted with further inquires and demanded details of Cayman Islands and other offshore entities. It was eventually revealed that these entities accounted for nearly half of pre-tax net income. In the midst of the inquiry, Bristow’s then-CFO John Briscoe abruptly resigned prior to completing the response to the SEC. The company stated that he was looking to “pursue other business opportunities”, however he never ended up moving elsewhere. He simply quit. The CFO spot was then filled by an internal appointment, Don Miller, who had previously been in charge of Bristow’s M&A. Presumably Mr. Miller would have had little exposure to Bristow’s offshore tax operations. However, within just 9 business days, Miller then completed the final response to the SEC. Prior to running M&A at Bristow, Miller had spent 9 years with Enron North America. Prior to Enron, Miller had advised Enron from his prior position at Citigroup.

Shorting a stock based on expectations for an SEC action can take great patience. So instead, my focus of interest is how formerly utilized tax strategies may have allowed Bristow to underbid on projects such as the UK Search and Rescue operations. Even prior to any SEC action, to the extent that Bristow is unable to maintain such a competitive advantage, it would have a further negative impact on profitability for things such as UK Search and Rescue (among others). As of now, UK Search and Rescue, while only 11% of revenues, remains the one bright spot for Bristow, amidst sharply declining revenues elsewhere. Details of UK Search and Rescue are included in Section I. With nearly 50% of pre-tax income being parked in offshore tax havens, there is also the possibility that Bristow will have to repay substantial back tax liabilities at a time when it can no longer afford to do so. The actual prospect for an outright SEC action remains as a “put option” on the price of the stock.

SECTION III highlights the consistent failures of sell side research in covering Bristow. Recent reports by Cowen, Barclays and Credit Suisse have consistently downplayed or disregarded the recent negative developments and maintained lofty share price targets. In each instance, sell side analysts ignore obvious problems and simply echo the hyped up optimism of management. These reports have served to drive money into the stock, visibly propping up the share price. The sell side has consistently pumped the stock since it was trading at $60, and continues to pump it all the way down. Not surprisingly, these analysts generally come from the banks who have run Bristow’s past debt and occasional equity offerings over the years. Given Bristow’s constrained finances, the company is now a high priority investment banking client as it needs to raise money in the near term. More importantly, a number of the banks have served as lenders to Bristow. As a result, they are virtually certain to NOT issue anything that looks like concern over solvency.

In Section III below, I highlight the repeated examples from their research reports where they have ignored obvious problems which then quickly materialized and pummeled the share price. I also show how despite the ongoing implosion in the share price, these banks continued to pump the stock by simply quoting and echoing incorrect statements from Bristow management.

Section I – Bristow Group headed for a 45% decline

When I look for compelling shorts, I generally look for stocks which have at least 30-50% downside. And that is what I usually predict when I write about them in public.

But I have consistently found that these troubled stocks end up falling much more than 50% once their problems are exposed. Many of the stocks I have exposed quickly fell by 75-99%.

The mot important factor with each of those stocks above was to identify a near term catalyst.

In particular, readers should refer to my article on helicopter operator Erickson Air Crane which subsequently declined by 98%, now trading at around 60 cents down from $25. According to the subsequent lawsuits, the concerns I highlighted were the precise primary cause for the collapse in the share price.

As with Erickson, Bristow Group (NYSE:BRS) is set for a very substantial decline and there is also a near term catalyst.

To paraphrase an old joke:

Q: What’s the best way to become a millionaire ?

A: Start with a BILLION and run helicopter company.

I can’t decide whether I think that management at Bristow are truly bad actors (dishonest) or whether they are just incompetent bunglers. In reality, it doesn’t much matter because the effect has been the same. Yes, I get it, times have been tough for anyone servicing the oil and gas industry. The offshore helicopter industry has been hit particularly hard, as evidenced by multiple recent bankruptcies.

But the point is that management has continuously and repeatedly given dramatically incorrect reassurances to shareholders about Bristow’s performance and prospects. These guys have repeatedly demonstrated that they will say ANYTHING in an attempt to keep the stock up.

With each quarter comes a new set of excuses for the past, as well as promises for the future. But in each case, when the actual results do come out, management is somehow “surprised” by new negative factors. I will demonstrate this in great detail below.

In each of the past 3 quarters, the share price quickly fell by at least 20-30%following management’s earnings call due to disappointing “surprises” from management.

The upcoming quarter, to be announced in 9 trading days is going to contain some shocking new disclosures for investors. The share price will once again take a significant dive.

As we have seen repeatedly in the past, currency “headwinds” (historically from less significant regions for Bristow such as Asia and Brazil) have been a consistent theme in Bristow’s large miscalculations, leading to significant losses and drops in the share price.

In fact, the impact of massive unhedged currency exposures is about to get much worse.

But doesn’t Bristow hedge its currency exposure ? (No, they don’t)

I find it downright bizarre that a company with such tremendous currency exposure around the world does not even bother to hedge its exposure with futures or other contracts.

But this is indeed the case. Bristow does not hedge its currency exposure.

On page 21 of the 10K, Bristow notes that:

Generally, we do not enter into hedging transactions to protect against foreign exchange risks related to our revenue or operating expense.

In a subsequent presentation, Bristow addressed the question by stating that they simply “naturally hedge our currency exposure through client contracts when possible“. But this has clearly and consistently not worked at all, as demonstrated in recent quarters.

In the previous year, currency moves were not nearly as extreme as recent moves, yet “surprise” currency moves saw Bristow operating revenue decline by $98.6 million year-over-year. The hit to net income was $30 million. And again, these were not drastic currency moves.

In order to avoid breaching loan covenants, Bristow has been forced to cut its dividend by 80%, slash cap ex and eliminate cash bonuses for employees. The loan covenants were renegotiated in May. But in fact, all of this was BEFORE the new and negative currency developments occurred.

As we will see, due to recent extreme currency moves, things are about to get quite substantially worse for Bristow and so far management has clearly failed to disclose the full impact to investors.

Over just the past few weeks, Bristow has clearly been heavily impacted by due to the 15% fall in the British Pound (approaching 20% decline since last year). European (primarily North Sea) revenues comprise fully 50% of Bristow’s total.

I am primarily focused on the significant revenue / net income impact of the currency plunge. But given that Bristow has historically kept nearly half of its earnings “indefinitely reinvested abroad”, there could also be a negative balance sheet impact it the tens of millions of dollars.

Nigerian revenues are around 15% of total, which doesn’t seem overly large. But in June, the Nigerian Naira dropped by a massive 40% when the government stopped defending its historical peg to the dollar. Bristow had previously disclosed the potential for very substantial exposure to moves in the Naira. But because the currency has historically been pegged, no one has paid much attention to this. Following the move in the Naira, Bristow has disclosed nothing to the general public.

Note that I expect very little near term impact on the balance sheet from the Naira. In fact, Bristow may even be slightly net short the Naira (with more Naira liabilities than assets), however this likely amounts to less than $1 million. So the balance sheet impact is likely immaterial in either direction. Instead, the main impact from the Naira will be a plunge in revenues and sharp increase in Bristow’s ongoing losses.

Disclosure shortcomings – past and present

Just prior to Brexit, management insisted in SEC filings that it had absolutely no material exposure to any fall in the Pound. This limited the damage to the share price during the Brexit days. But shortly after Brexit,management quietly admitted that the exposure could in fact equate to tens of millions vs. 2016 operating income. In fact, I now think it could be much more.

Following the collapse of the Naira, management has made no disclosure of the actual impact. On its Nigerian operations. But as we will see below, at a minimum it is likely to equate to 22% of Bristow’s entire 2016 global operating income. This will soon need to be disclosed in the upcoming earnings call. And, as with the Pound, I suspect that the actual number could be much greater.

Despite the enormity of its impact, the crashing Naira has not even been noticed by Bristow investors or reflected in the share price. The share price did dip briefly on Brexit, but has since recovered much of those losses.

As it has repeatedly done in the past, Bristow management has continued to publicly put on a positive spin to support the weak share price. As expected, sell side analysts simply echo the positive statements from management.

These statements will be dissected in detail below.

When times were good, Bristow refused to issue much stock at share prices over $60 and instead continued to lever up substantially with debt. The share price has since fallen to as low as $10.80. Debt load now exceeds $1.1 billion vs. a market cap of around $450 million. Multiple competitors have recently already gone bankrupt but are still operating. They are undercutting Bristow and price and flooding the market with used helicopters, eliminating Bristow’s ability to monetize their own.

Earlier in 2016, bottom feeding “value hunters” might have been tempted to think that Bristow trades at a discount to book value.

But in terms of “asset recovery” in a bankruptcy situation, Bristow’s helicopter assets are now worth far less than the book value stated on the balance sheet. Just in May2016, following the bankruptcy of competitor CHC, Oil and Gas People noted that:

With the market conditions for helicopters so poor there is a lot of idle aircraft around, if CHC have 100 or so that they want to get rid of, then how many do the other big players in the market have? The leasing companies of course won’t want these aircraft back but under Chapter 11, they have no choice. With regards to buy back, the market is flooded with unused helicopters with supply far outstripping demand. The leasing companies have a couple of choices, receive the airframes back under chapter 11 and receive no payment at all or sell the airframe at a discounted market value price and get shot of it?

For 2016, Bristow already recorded a loss on impairment of $55 million and an additional loss on disposal of assets of $30 million.

Because the assets are so heavily impaired, and because of the heavy debt load, the downside in the share price remains quite large.

The point of this article will be that when details of massive exposures incurred in recent weeks becomes public, the stock will quickly fall by 40-50%. It may take more than one day, but I expect it to settle at around $6-8.

We have seen this repeatedly in the past. In each of the past 3 quarters, the share price quickly plunged by at least 20-30% due to new surprises disclosed at the last minute by management.

Anyone foolish enough to see this information and still hold through another disastrous upcoming earnings call certainly deserves the losses they have coming.

Yet despite an almost inevitable plunge in the Bristow share price going forward,short interestin Bristow Group remains below 10% of the float and the borrow is cheap at around 1%.

Company overview and investment summary

Headquartered in Houston Texas, Bristow Group is an operator of helicopter services in various locations around the world. The majority of its consolidated operating revenues (76% of total) come from providing flight services to oil the offshore oil and gas industry, with heavy exposure to the North Sea (Britain and Norway). Operating income is also heavily exposed to operations run in Nigeria. The firm also provides Search and Rescue services as an adjunct to various governments as well as running a helicopter training school in Florida. However, both of these segments account for much smaller portions of revenue.

Bristow has plunged by 80% since mid 2015, largely due to the plunging price of oil. The stock was hit again on the Brexit vote in June due to Bristow’s heavy exposure to the UK, but since the stock has regained much of the brief Brexit losses.

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Bristow Group has been around in one form or another for decades. Like other helicopter operators, the company has massive cap ex requirements and also needs to make use of massive leverage (debt).

Over the past 3-4 years, the company has been forced to spend $2.5 billionon cap ex. This was achievable when markets were strong. Now, it is not.

Bristow could have easily issued tremendous amounts of stock at prices in the $60’s in previous years (when its market cap was close to $3 billion), but instead the company largely chose to lever up and continue raising debt. It now sits under a pile of $1.1 billion in debt with a market cap of only $450 million.

Over the past year, operating cash flow was just $116 million, which was not nearly enough to support the $372 million in required cap ex. To investors, Bristow continues to state that it has “liquidity” of $360 million. But in fact it only has cash of $104 million, down from $130 million last quarter.

When times were good (think oil at $100), Bristow was actually able to turn a decent profit. But as the price of oil plunged, revenues have fallen. Margins have been hit hard. Multiple competitors have filed for bankruptcy such that they are flooding the market with their unused equipment and lower priced services.

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The effect on Bristow’s financials has been dire.

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Things did appear to have bottomed starting in May/early June when several things happened at once. These factors had tempted a number of investors back into the stock, preventing it from collapsing altogether.

First. The price of oil rebounded sharply from lows of around $25 per barrel in February to as high as $52 per barrel in June.

Second, management was able to renegotiate covenants on its debt agreements with banks, to avoid otherwise going into default.

Third, in June (when oil peaked at $52) several members of management made a few purchases of stock near its multi decade lows. However, total purchases amounted to just $464,000, the majority of which came from the CEO. But in general, it was starting to appear that things might get better for Bristow.

But late June was extremely unkind to Bristow.

The surprise Brexit vote caused the British Pound to plunge by nearly 15% from its recent levels. That takes the decline to well over 20% since mid 2015.

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Like many stocks, Bristow’s share price took a hit on Brexit. It fell to a new multi decade low of $10.80 (intraday). But then, along with the rest of the market, Bristow stock rebounded, returning to current levels.

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Contradictions vs. SEC disclosures – a quick “about face”

(Note: information in this section is separate from the information in Section II, which details the SEC’s inquiry into offshore tax havens.)

Part of the rebound in Bristow’s shares price was likely due to the fact that in original disclosures (from the 10K in May), Bristow has disclosed that its exposure to the Pound was “not meaningful”. At the time of the disclosure, the Pound was at $1.55-1.58.

Investors were clearly soothed by management’s existing disclosure.

Yet two weeks AFTER the Brexit vote and the Pound collapse to around $1.30, management gave a presentation in London (Evercore) where it quietlyestimated that each 10% drop in the Pound would end up equating to a $10-12 million drop in operating income. So we should likely expect the real impact to be at $20 million or more (up from a previous statement of zero in the 10K).

So within just a few weeks, their estimate of currency exposure went from zero to potentially over $20 million.

This alone equates to a 50% increase vs. the operating loss just reported. From this, it quickly becomes clear that management has zero clue what is going on with its currency exposures.

In fact, if past earnings calls are any guide, we should expect the impact to be even bigger.

The situation in Nigeria looks like it could ultimately have a far greater impact. Yet (true to historical form) management has so far publicly disclosed nothing about the impact of the Naira.

Nearly all of Bristow’s African revenues come from the oil producing country of Nigeria. For the past year these African revenues comprised fully $255 million of total revenues.

Little noticed disclosure previously noted that Bristow’s exposure to the Naira was significantly greater than exposure to the Pound. Based on their original forecasts, a 10% change in the Nigerian Naira would equate to a 5.6% drop in operating income. So the estimated impact was already for a 22% drop in operating income (or rather a further 22% increase in operating loss).

But again, given that management grossly underestimated its exposure to the Pound, I believe that Bristow could actually be far more exposed to the Nigerian Naira.

Because of the long standing fixed peg 200:1, most would have assumed that there would be no need (and no ability) to effectively hedge the Naira.

But in late June, the Naira was unexpectedly unpegged from the dollar and it immediatelyplunged by 40%. It has remained at these new levels.

Nigeria’s currency plummeted more than 40% against the dollar on Monday, the latest sign that low crude-oil prices continue to disrupt the economies of some major oil-producing nations.

Anyone with exposure to Nigeria (ie. Bristow in particular) should have seen this coming for some time. Even back in February, US News reported that:

…Money changers sit idle, with no dollars or euros to sell.

“We’ve run out of foreign exchange,” says Shehu Mahmud, the acting chairman of an association of money changers in the capital Abuja…. Already, the currency [Naira] has lost more than 50 percent of its value on the black market.

As we have seen in Venezuela, the plunge in oil prices has led to dramatically lower production as well as increased political unrest. The 40% plunge in the Naira is certainly going to contribute to further instability in Nigeria.

There are two realities that need to be faced with respect to this $255 million in historical Nigerian revenues.

First, even if revenue were to remain unchanged in Africa, profitability on these revenues will now drop to near zero because much of the cost basis (including fuel, offshore pilot and mechanic costs etc.) will be in dollars while the revenues coming in will be denominated in now-devalued Naira.

But based on this, the second reality is that it will likely make very little business sense to continue operating in Nigeria with the now devalued currency. As a result, up to $255 million in historical revenues is now likely now in question.

There is double-digit inflation, a lack of dollars (which prevents investors easily repatriating profits) and domestic terrorism, including bombing of oil pipelines, putting a further dent in government coffers.

“The naira is going to sink further, and it’s a formula for a disaster,” says Steve Hanke, professor of applied economics at The Johns Hopkins University. “Capital flight will accelerate so disrupting foreign direct investment.”

The weak currency, which looks set to get even weaker, will likely scare new investors away and current investors will be increasingly likely to pull their money out of the country. And the country’s growth will slow without the investment dollars.

As we will see below, losses from the Naira implosion could well have significant implications for Bristow’s massive debt situation and new covenants.

But what about UK Search and Rescue

While in London, and while ignoring the problems in Nigeria, management clearly attempted to over-emphasize its one bright spot: that UK Search and Rescue operations would see little impact from Brexit. Yes, this stability would be a mild positive. However, such revenues accounted for just 11% of revenues in 2016 vs. 76% for oil and gas operations.

To put this in perspective, revenues from Nigeria were 40% more than revenues from Search and Rescue.

In fact, Bristow won this contract way back in 2013 on a competitive bid vs. now bankrupted CHC Helicopter Group. At the time, Bristow was a $3.5 billion company with a $70 stock price and could afford to take chances on the bid. At the time, CHC was also very healthy and was preparing for a $530 million IPO which would value CHC at over $3 billion. Yet even then CHC refused to bid anywhere near as low as Bristow.

CHC’s COO Peter Barlotta leaked an email to the press about the low ball bidthat Bristow used to win the contract.

In the email, Bartolotta also reveals that one of the other bidders has tendered a bid some 20% lower than that of CHC’s, adding: “We don’t have insight to the financial or other motivations of competitors. But we know that the economics at a price 20 percent lower than our interim bid simply aren’t right for CHC.”

The winner of the contract in 2013 turned out to be Bristow.

Despite undercutting CHC by 20%, to a level which apparently makes no economic sense, Bristow still described its Search and Rescue operations as being among its most profitable. It is entirely unclear to me how this could be the case.

However, as mentioned above, in 2015, the SEC began inquiring about Bristow’s use of offshore tax havens to minimize taxes paid on overseas income. Specifically, the use of Cayman Islands entities was a point of focus.

The SEC and tax angles here are an entirely different component of the short thesis. As a result, I have included a detailed Section II which lays out this information. There are two key points: First, to the extent that Bristow was using an unsustainable tax advantage to compete on UK SAR, the end of this advantage will soon hit profits. Second, to the extent that Bristow improperly evaded US taxes, it would need to repay those taxes NOW – at a time when it certainly cannot afford to do so. The information is well worth reading and has likely not been read by most investors in Bristow, so I would strongly encourage readers to go through it.

The revenue value of the 10 year Search and Rescue contract , which began in 2015, was originally disclosed specifically as £1.6 billion (Pounds) when the exchange rate was close to 1.6 GBP/USD. That would have equated to around USD$2.5 billion, or roughly $250 million per year in revenues.

Yet despite the 20% drop in the British Pound since then, management continues to use the original translated value of the contract in presentations, including the presentation in London. As always, despite past experiences, Bristow describes the Search and Rescue revenues as being “naturally hedged“, rather than actually hedging the revenues financially. In other words, Bristow continues to not hedge currency exposure.

Management’s discrepancy here amounts to nearly $500 million over the life of the 10 year contract.

In any event, even assuming the highest possible estimated contract value over 10 years, Search and Rescue revenues remain small, amounting to less revenue than Africa (or even Asia for that matter).

And keep in mind that competitor CHC had its own Search and Rescueoperations, which also accounted for around 10% of revenues. Shortly before filing for bankruptcy, CHC’s CEO had a conference call with analysts and investors to stress the “stability” provided by these Search and Rescue revenues.

But again, somehow Search and Rescue is where management chooses to direct our attention ahead of the upcoming earnings call. It is really the only positive factor than can be discussed, amongst many larger negatives.

As an aside, little impact expected from Norwegian Krone

It should be noted that previous disclosures also indicated a heavy exposure to the Norwegian Krone. However, the Krone has not been particularly volatile. I expect little impact from anything relating to the Krone.

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Insiders are already fleeing the sinking ship, as management continues to publicly reassure

In a June 8K filing, Bristow announced that it was terminating cash bonuses for employees. It did note that it was handing out a few million shares in bonuses to top management, but these are most likely not highly prized by employees who have seen their existing equity awards plunge by 80% in the past year. The value of their past bonuses has quite literally evaporated, such that getting new shares of the rapidly plunging stock likely means little.

On June 27th (just after the Brexit vote), Bristow appointed William Higgins as a new director. The Heli Hub industry journal was notably focused on Mr. Higgins past bankruptcy experience with Leslie controls in a headline:

Bristow Group adds new Board director with particular experience

Heli Hub noted that:

We are not clear on why Mr Higgins’ skills in bankruptcy protection have been noted, whether that is something Bristow feel they might need, or whether it is an SEC requirement to provide those details in this sort of statement.

Getting a clearer picture of default risk

I have previously expressed my concerns about helicopter operator Erickson Air Crane, which then declined from $25 to just 60 cents. But that company never formally filed for bankruptcy.

But anyone involved in the helicopter industry should be very familiar with bankruptcy.

In the 1980s and 1990’s, Bristow was fully owned by British and Commonwealth Holdings, which went bankrupt during that time.

Bristow was then acquired by Offshore Logistics, which itself had gone bustduring the prior oil price downturn.

When competitor CHC filed for bankruptcy in May of 2016, it seemed that the last straw was a fatal flight accident that grounded much of its fleet. Likewise, in June of 2016, Bristow announced that it was grounding most of its Airbus EC225 helicopters following that crash.

This follows two serious helicopter crashes by Bristow itself near Lagos, Nigeria. In the first crash, 6 of the 12 passengers were killed.

An article from Bloomberg is now raising the issue that the most recent crash in Norway “has sparked a debate over whether the industry’s deepest cost cuts in 15 years are imperiling safety.”

Bristow continues to struggle under over $1.1 billion in debt and must meet heavy cap ex requirements if it wishes to stay business. In London, Bristow now noted that it would be attempting to defer capex in order to preserve cash.

The effect of the currency implosions is that Bristow will now likely be running up against its loan covenants AGAIN, just a few weeks after revising them with banks.

Again, it is important to remember that the currency implosions above have occurred just within the past few weeks, and subsequent to the prior loan negotiations which just took place.

Making matters worse, Bristow’s ability to generate cash from asset sales and returns now appears to be under pressure as well.

In the 10K, Bristow had as a risk factor that:

In May 2015, a global competitor filed for Chapter 11 bankruptcy protection and announced its intention to reject leases resulting in the return of approximately 90 leased helicopters to lessors. This significant return of aircraft into an already oversupplied market could undermine our ability to dispose of our aircraft and could have a material adverse effect on our business, financial condition and results of operations.

Keep in mind that this was one year before the additional bankruptcy of Bristow’s largest competitor, CHC.

The reorganization is expected to strengthen CHC’s financial position by reducing long-term debt and enhancing financial flexibility while allowing the Company to manage and operate its fleet of aircraft. CHC expects day-to-day operations to continue without interruption throughout the court-supervised restructuring process.

Under the bankruptcy, CHC is flooding the market with excess, unused helicopters as well as potentially undercutting Bristow on price. This should be obvious, CHC will now be free of much of its long term debt obligations, but will certainly need to cut price in order to attract customers during its bankruptcy.

Such cost cutting and emphasis on low pricing was significant enough to be disclosed as a separate risk factor in the recent 10K.

A focus by our clients on cost-saving measures rather than quality of service, which is how we differentiate ourselves from competition, could reduce the demand for our services.

The bankruptcy filing from CHC just happened in May, such that we have only begun to see the impact of the increased pressures on Bristow.

Yet, as described below, various sell side analysts seem to suggest that bankruptcy means that CHC will no longer even be in business or competing with Bristow. These sell side analysts are merely echoing inaccurate statements from Bristow management.

Are Bristow bankruptcy concerns overblown ?

When defaults happen, they often happen in a various abrupt stages.

CHC Group filed for bankruptcy in May, but it had “decided not to make” an interest payment as early as April 15th.

We exited the fiscal 2016 third quarter with liquidity of $377 million and we are focused on strengthening and increasing the quality of our liquidity.

Despite the assurances, within just a few weeks, CHC Group had defaulted on its debt payments and filed for bankruptcy.

We should remember that Bristow also boasts of having recent “liquidity” of $360 million. But also remember that only $104 million of this is cash. The remaining $256 is just more debt. Even though cash had actually fallen by $28 million, the company stated that “liquidity had increased by 20%”. And again, these figures are all prior to the recent currency implosions.

The relentless “optimism” of Bristow management

The point of this section is as follows:

As the share price was plunging to multi decade lows, management gave a presentation in London which then boosted the stock price by 10% that day. The presentation was typical for Bristow and outlined how everything was going great and that bankruptcy was not a risk. Yet statements in the presentation clearly contradict recent SEC disclosures.

Investors should note that management has been delivering the same optimistic pitch over and over again since mid 2015, during which time financial results have continuously plunged and the stock has dropped by 80%.

Management will (and does) say just about anything, even when it is downright silly.

Following the sequential resignations of multiple members of senior management in recent months, Bristow tried to spin these departures as a positive with a press release entitled.

Bristow Group Strengthens Operational and Leadership Structure

Prior to the release of earnings for the September quarter (released in November), Bristow’s share price sat at $37 (already cut nearly in half since January). Management’s positive spin on earnings consisted of its usual delusional optimism.

I am proud of our team’s progress during the quarter in implementing our economic restructuring initiatives designed to enhance Bristow’s leading competitive position and financial strength,” said Jonathan Baliff, President and Chief Executive Officer of Bristow Group. “We have been successful in reinforcing our financial flexibility through an expected deferral of approximately $100 million of capital expenditures out of fiscal 2016 with further deferrals expected over the next five years. We also are announcing a new two year $200 million term loan which will provide additional liquidity in light of this downturn.

In particular, management simply blamed the effect of a strong dollar for additional losses of $22 million. But if we could just ignore that….then things would look great.

Our results for the September 2015 quarter included a number of negative items, including the impact of the strong U.S. dollar, which detracted from our underlying performance where our regional operations delivered respectable results led by Europe Caspian and Asia Pacific. Excluding the impact of the foreign exchange losses, we would have reportedadjusted EBITDAR of $122.7 million, in line with the prior year quarter with an improved adjusted EBITDAR margin of 28.9%.

And with the stock in the $30’s management disclosed that it had even approved a $150 million stock buyback program. (With cash getting more and more scarce for Bristow, this ruse clearly has had little effect on the share price. )

Management noted that it was lowering guidance for the full fiscal year(ending March 2016) from $3.10 – $3.75 to an EPS of $1.80 to $2.40.

So management’s original estimate was initially wrong by around 40%. (Hint: it then gets worse).

THE POINT IS THIS:

INVESTORS HATE SURPRISES.

THE STOCK BRIEFLY ROSE BY 15% PRIOR TO THE EARNINGS RELEASE IN NOVEMBER.

FOLLOWING THE RELEASE OF EARNINGS AND THE CONFERENCE CALL IN NOVEMBER, BRISTOW’S STOCK QUICKLY DROPPED BY 20% (TO BELOW $30), HITTING NEW LOWS FOR THE YEAR.

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So then in February, Bristow released earnings for the December quarter. By this time the share price had now fallen to $20-25 (prior to earnings).

Not only did Bristow reaffirm guidance of positive EPS for the year of $1.80 to $2.40, but the press release was again filled with reassuring language:

Our third quarter results demonstrate the success of our diversified business development and economic restructuring efforts in the face of unprecedented challenges for our oil and gas clients. These initiatives demonstrably improved our third quarter margins while improving our competitive position and financial flexibility,” said Jonathan Baliff, President and Chief Executive Officer of Bristow Group

The company went on to tout:

Search and rescue strength

Cap ex cuts

“Improved liquidity”

More loans

Financial flexibility

Sound familiar ?

But the reality was that (surprise) revenues had declined by 21.2%. (Surprise) Currency exposure hit revenues by $14.9 million. (Surprise) Bristow’s dividend was cut by 80%. (Surprise) a steep drop in the Aussie Dollar caused additional losses.

THE POINT IS THIS (ONCE AGAIN):

INVESTORS HATE SURPRISES.

FOLLOWING THE RELEASE OF EARNINGS AND THE CONFERENCE CALL IN FEBRUARY THE STOCK IMMEDIATELY DROPPED BY 30%, HITTING NEW MULTI DECADE LOWS OF $11.90.

(click to enlarge)

That takes us to May.

By the time full year earnings were released in May, the stock had slowly recovered to around $15 again, supported largely by a 60% rise in oil prices off of the February lows.

Then, (surprise) rather than a $2.00 PROFIT (as announced in both November and February), management announced a LOSS of $2.12. So once again, even the revised-lower numbers were off by a very long shot.

In May, management’s new spin now turned to soothing investor fears over looming bankruptcy.

In fact, in reality, cash had DECLINED by $30 million since December. All Bristow had really done was increased its borrowing ability by altering loan covenants. Surprise !

Once again, Bristow was unpleasantly surprised by the impact of foreign exchange on its results and had not given investors any warning. Surprise !

Additionally, changes in foreign exchange rates during fiscal year 2016 decreased operating revenue by $14.7 million and $98.6 million quarter-over-quarter and year-over-year, respectively.

THE POINT IS THIS (FOR A THIRD TIME):

INVESTORS HATE SURPRISES.

FOLLOWING THE RELEASE OF EARNINGS AND THE CONFERENCE CALL IN MAY THE STOCK IMMEDIATELY DROPPED AGAIN BY 25%, FROM $15.50 to $11.50, AGAIN TESTING MULTI DECADE LOWS.

(click to enlarge)

As Bristow’s stock was fighting further declines, it was supported by a 20% spike in oil prices. Oil prices quickly jumped from $43 to almost $52.

(click to enlarge)

But in fact, this was all BEFORE the Brexit crash, the Pound slump and the surprise Naira implosion.

In May, the situation was looking grim for Bristow. Hence the new multi decade lows for the share price.

But since that time, things have actually gotten much, much worse.

The Pound has dropped 15%, exposing Bristow to tens of millions in further losses.

The Naira has imploded, affecting $255 million in African revenues, and (supposedly) equating to “only” a 22% further increase in net operating losses. (Again, given the sheer size of the devaluation, I suspect the impact could be much greater).

Likewise, the price of oil has now declined by 10-15% from June highs.

This has all happened in just a few weeks.

(click to enlarge)

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Yet rather than showing further decline, the share price has now stabilized at around $13.

Management’s Evercore presentation in London on July 12th caused the stock to rally 10% in a single day. However, it is notable that volume was light.

THE POINT is that we have seen repeatedly seen this game from Bristow management in the past.

Once again, Bristow management has failed to disclose the massive impact of recent currency swings and attempts to divert attention to things like the tiny Search and Rescue business and its bogus “increased liquidity” from simply adding more debt capacity in the face of dwindling cash.

All of this calamity has happened just a few weeks after Bristow renegotiated its loan covenants with lenders as part of its $1.1 billion in outstanding debt.

The near term catalyst will be the new disclosures (surprises) raised on the upcoming conference call. Bristow will then yet again set new multi decade lows, which I expect at around $6-8.

Helicopter operators – past experience

A while back, I highlighted my concerns about helicopter operator Erickson Air Crane , including the fact that insiders and board members were set to dump large amounts of stock. The stock immediately plunged by 30%. A number of analysts and bloggers were quick to defend the stock even in the face of the inevitable. Jim Cramer even touted the stock on Mad Money. But as investors looked more deeply into the equity and credit fundamentals, the ongoing deterioration became clear and the stock continued its descent.

Erickson had been trading at around $25 at the time I wrote about it. It now trades for 60 cents.

(click to enlarge)

My article was explicit and clear. There should have been little doubt about what to expect. Yet articles quickly surfaced from those determined to catch the falling knife.

Positive articles that came out AFTER my analysis included the following:

– CHC now trades for just 40 cents (even adjusted for its reveres split) following bankruptcy.CHC had just field for bankruptcy earlier this year and the Wall Street Journal noted that:

CHC is now asking the U.S. Bankruptcy Court in Dallas, to let it drop at least 90 aircraft from its fleet of about 230 helicopters, most of which are leased, as part of a broader restructuring that will target more than $2 billion in debt. The Canadian company said it can “no longer bear the weight” of its burdensome debt structure and expensive fleet amid declining oil prices and the resulting drop in demand for its services…. CHC is one of two global companies alongside Houston-basedBristow GroupInc. that dominate the business of ferrying workers and cargo offshore for energy companies and have been forced to shrink and cut costs.

The hype on Bristow

As with Erickson and CHC, there has been no shortage of “value hunters” being burned on the way down during Bristow’s straight-line descent from $60 to as low as $10.80.

On March 2nd, 2015, when Bristow was still profitable and supposed to be paying taxes, the company received a letter from the SEC inquiring into “foreign jurisdictions, the effective tax rates in those jurisdictions, and the amount of pre- tax profit in those jurisdictions”. The SEC also wanted to know more about “Foreign earnings indefinitely reinvested abroad” – which is a corporate code name for earnings on which the company hopes it will never have to pay US taxes at all.

In the prior year, Bristow had reported paying a US effective corporate tax rateof 23.4%. However, this was actually the result of a number of special one time items. Without the benefit of those items, Bristow’s effective tax rate in the US was reported as just 13.7%.

Bristow’s CFO (at the time) John Briscoe, compiled the information and responded to the SEC on March 13th, 2015, including the following table:

(click to enlarge)

There are a few things to notice in Briscoe’s response:

1. In March, CFO Briscoe only responded to the SEC with 5 overseas jurisdictions: The UK, Nigeria, Norway, Australia and Trinidad.

2. The overwhelming amount of pre-tax net income comes from the UK, then Nigeria. The other areas showed net losses (not net income).

3. For the UK, Bristow reported a tax rate of just 10.9%.

4. For Nigeria, the tax rate was reported as 89.4%. But this was explained as follows: “For example, in Nigeria, we accrue and pay taxes based on our gross income by applying a deemed profit margin of 20%. Therefore, a year of poor financial performance resulting in low or negative pre-tax earnings does not translate to significant tax expense reduction in Nigeria.”

On May 4th, 2015, the SEC wrote another letter to Bristow in which it made clear that Bristow had not responded fully to the previous letter, and in fact had omittedoverseas jurisdictions amounting to 48% of its pre-tax income, which should amount to to $259 million.

you have detailed the pre-tax income for your primary foreign jurisdictions, which represents 52% of total net pre-tax foreign income… Please explain to us the nature of the remaining amount of pre-tax income from foreign jurisdictionsthat are not included in your response to prior comment 2 of $259.3 million

The SEC also requested that Bristow identify the foreign subs whose earnings were indefinitely reinvested.

The SEC had instructed Bristow to respond to this request within 10 business days. However, Bristow responded back that it needed until June 1st to get the required information.

On June 1st, Bristow responded, including the two tables below.(click to enlarge)The key points to notice from the 1st table above are as follows:

1. In the new response, Bristow now included 11 jurisdictions rather than just 5. The newly included jurisdictions suddenly includes offshore tax havens such as Guernsey, Panama, Cayman Islands and the Netherlands, which Bristow had previously omitted.

2. Suddenly we see the Cayman Islands account for $112 million in Pre-tax income, second only to the UK.

3. Of course, the Cayman’s have a tax rate of just 0.7%. That is to be expected.

4. But we now see that US pre-tax income has been fixed at negative$14.5 million.

(click to enlarge)

The key points to notice from the 2nd table above are as follows:

1. The largest foreign sub is BL Holdings II CV, which is based in the Netherlandsand is responsible for just under $100 million in Pre-tax income (roughly 40% of pre-tax income for the year).

2. For the Netherlands, the tax rate is just 0.8%

3. Including the other foreign subsidiaries amounts to a total of $124 million in pre-tax income, nearly one half of total pre-tax income for the year being “indefinitely” re-invested abroad

4. Bristow did NOT disclose conducting substantial operations in the Netherlands

John Briscoe, who will be leaving his current position as Chief Financial Officer to pursue other business opportunities.

In fact, it is now almost 1 year later. According to Bloomberg, he former CFO has not been employed elsewhere. According to LinkedIn, the former CFO lists himself as being “retired” and offers his services as an energy consultant.

In other words, CFO Briscoe simply quit Bristow with no other job lined up and so far has not found any other employment. Contrary to the company press release, he was certainly not “pursuing other business opportunities”.

This seems quite unusual. Bristow’s choice of a replacement was equally unusual.

Bristow appointed Don Miller as the new CFO. It is noteworthy prior to his time at Bristow, Miller had spent 9 years at Enron North America. Prior to his time at Enron, Miller was one of Enron’s bankers. Miller had spent 12 years as a an energy corporate banker at Citicorp. Most will remember that Citigroup had a very intimate relationship with Enron during its spectacular rise, and ultimately paid over $1.6 billion to settled claims that Citi helped Enron defraud investors. The New York Times reported that:

I understand that many (perhaps most) investors do not read SEC correspondence at all. As a result, many investors may interpret the letter above to be an “all clear” from the SEC. This is clearly not the case.

Just to demonstrate this, I am including an identical boilerplate letter received by MDC Partners (NASDAQ:MDCA) following its own correspondence with the SEC.

The SEC had been inquiring into a wide variety of accounting issues at MDC for a number of months. As with Bristow, there were multiple rounds of correspondence back and forth. The correspondence ended with the following letter, which is (quite obviously) identical, verbatim to the one received by Bristow.

At the time, I had been preparing a lengthy bearish article on MDC, but the subpoena came out first and the share price tanked before I could publish.

THE POINT:

My point is that investors simply don’t read SEC correspondence. And even when they do, they seldom understand what they are reading.

How are the SEC inquiries related to the current situation at Bristow ?

When oil prices were higher and Bristow was reporting profits, it was doing so while reporting a very low corporate tax rate. During the SEC inquiries, Bristow previously reported a rate which appeared to be 23%. But excluding special items, this rate was just 13.7%.

However, it remains the case that various divisions within Bristow are taxed independently of the corporate parent due to use of offshore jurisdictions. So even when the parent appears to be losing money, various divisions SHOULD likely be subject to taxes. The most obvious candidate for this would be the UK Search and Rescue operations. Although UK Search and Rescue comprises just 11% of revenues and is relatively fixed (not growing), Bristow management continues to highlight them due to their supposed stability and profitability.

Yet we saw above that somehow Bristow was able to undercut competitor CHC by at least 20% on this contract, to a point where CHC said it did not make sense financially.

We have also seen from SEC disclosure that Bristow’s UK’s corporate tax rate is less than half of the listed corporate tax rate for that year.

We also saw from the SEC disclosure that nearly half of Bristow’s pre-tax net income was being posted in offshore tax jurisdictions, mostly in domiciles where it conducted no operations, and mostly in jurisdictions where it paid virtually no taxes.

There are two potential scenarios here. We could end up seeing one, both or neither of them, depending on how the SEC shakes out.

First, as it applies to current financials, to the extent that Bristow is found to be inappropriately evading taxes via offshore entities, it could still have a financial impact on current financials – even when the corporate parent appears to be losing money and not liable for taxes. This would presumably happen at the division level.

Second, to the extent that there have been taxes avoiding in past years, when Bristow was profitable, it would create a large tax liability payable now – when Bristow can least afford it.

Section III – Sell side coverage of Bristow has been consistently misleading and flawed

As my regular readers know, I frequently watch for sell side BUY recommendations and take the opposite side of the trade when such recommendations are deeply flawed. A few weeks ago, several sell side shops were busy hyping shares of OraSure Technologies (NASDAQ:OSUR). The hype was that OraSure was set to continue with a lucrative contract with drug giant AbbVie (NYSE:ABBV). The result of the sell side hype was that OraSure was rising sharply on strong volume.

When I wrote about OraSure, I performed far deeper research than the shallow analysis of the sell side. I demonstrated that (contrary to sell side research) OraSure was “virtually guaranteed” to lose this contract, which would cost the company $40 million straight to the bottom line. OraSure shares quickly tanked by as much as 20%.

With Bristow, the key movers of the stock include Cowen & Co, Barclays and Credit Suisse, as shown below. A closer look reveals that all of them have touted or supported the stock, and all of them have been 100% wrong in every instance going back well into 2015. Yet they persist in touting and supporting the stock even now. (Hint: Bristow is in deep need of raising money and is therefore a high priority investment banking client).

The graphic below shows the dismal ratings history for each of these three investment banks.

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Cowen & Co. Research

One of my favorite sell side shops to get short on is Cowen & Co. It seems that whenever a company is in obvious need of raising large amounts of money, investment banker Cowen is there with an “Outperform” rating and a lofty share price target. As a result, I have often gotten short Cowen research names.

Most recently, when I wrote about Revance Therapeutics (RVNC) the stock had just soared 50% to over $40 based on hype from Cowen that the company was likely to be a “buyout target”. Cowen placed a $55 target on Revance. The evidence was transparently obvious that Revance’s data was deeply flawed. Not only would there be no buyout, but I predicted that Revance’s share price would be cut in half. Revance’s data was indeed highly problematic and the stock has since plunged to just $13. Despite the obvious problems, Cowen simply maintains a $55 target on the stock.

With Bristow, Cowen’s July 18th outperform rating saw the shares climb by nearly 7% on substantial volume for the day. Within 2 days, nearly all of those gains had already faded.

Be it equity or debt, Bristow is an obvious investment banking client because the company is in dire need of money to offset falling revenues and service its $1.1 billion in debt. Cowen has a far weaker investment baking franchise than some of the “bigger boys” on Wall Street. As a result, the firm appears to have consistently higher share price targets which curries favor with investment banking clients. This is why I end up doing so well shorting Cowen research names.

Just as Bristow’s earnings were announced in November (as highlighted in Section I above), Cowen came out with a research note in which it made a number of supportive statements, all of which echoed the statements of Bristow management. Despite the obvious disappointments and the plunge in the share price, Cowen noted:

Clearly this was preposterous. Cowen went on to parrot management’sassertions on CapEx deferrals, cost savings and the strength of UK SAR.

The firm maintained a huge $41 target on the stock even when the share price plunged to $30 and below.

Then, as we saw above, earnings in February were a disaster that should have been easily predictable. Even as the business environment deteriorated substantially, Cowen maintained its Outperform rating and $41 target into February even as oil was approaching new lows of $25.

In fact, Cowen even reiterated this rating immediately before earnings were announced on February 8th. As we saw, results were an absolute disaster and the share price plunged to new multi decade lows of around $11.

So the next week, Cowen did cut its target from $41 all the way down to $16. But it has continued to maintain its “Outperform” rating ever since.

As part of its report, Cowen described an “attractive risk / reward” and noted that “we see concerns over covenants in the credit facility to be overdone”. As we know, the stock continued to decline and Bristow was forced to renegotiatecovenants – just a few weeks later.

Back in June, Cowen actually re-upped its target price to $18 based on rising oil prices and the newly revised covenants. But since that time, oil prices have resumed their decline, currency “headwinds” have created very obvious near term problems and the CHC bankruptcy is flooding the market with cheap helicopters and underpriced competition.

Barclays Research

Barclays has been covering Bristow since the middle of 2015. Barclays has consistently rated the stock an “Equal Weight” (NYSEARCA:HOLD), and simply lowers its target price each time the stock plunges.

When the stock was in the $50s, Barclays told us it was worth $58.

When the stock was in the $30s, Barclays told us it was worth $40.

When the stock was in the $20s, Barclays told us it was worth $38.

And now that the stock is in the teens, Barclays tells us it is worth $20-22.

When the stock (soon) gets into the single digits, I expect that Barclays will once again downgrade the stock to around $10.

Barclays has been a member of Bristow’s banking syndicate, such that despite the continuously falling share price, Barclays has consistently told investors to continue holding the stock. And in June, they even upgraded the stock to an “Overweight”.

Most recently, Barclay’s noted:

We believe BRS’s first order of business, before any need to tap the capital markets, is to pursue sale leasebacks of up to $340 million of UK SAR aircraft, which may prove attractive sale leaseback candidates despite our cautious view of the leasing market, as well as asset-based financingfor up to $125 million of UK SAR bases and infrastructure,

Quite obviously this simply ignores the impact of the CHC bankruptcy under which we are now seeing the market floodedwith unused helicopters. It is an obvious point that no serious analyst should miss.

The recent reports from Barclays seem to quote management almost verbatim in touting the importance of UK Search and Rescue, Capex deferrals and the “advantages” of the CHC bankruptcy for Bristow. (See above on the impact on pricing).

Credit Suisse Research

Like Barclays, Credit Suisse has continuously told investors to keep holding Bristow (a “Neutral’ rating), despite a relentless 80% decline in the share price. And just like Barclays, each time the share price plunges, Credit Suisse waits until AFTER the fact to lower its share price targets.

As the share price declined since last year, Credit Suisse went from a target of $65 to $50 to $35 to $20 and now most recently to just $15. At no time has Credit Suisse ever called Bristow a sell. Like Barclays, Credit Suisse is also one of Bristow’s lenders, so this should be expected.

So Credit Suisse has been telling us to hold the stock all throughout this 80% decline. But lately, this recommendation gets even harder to understand.

The most recent report from CS describes the “industry in a tail spin” as customers are doing more with less. CS then lowered its estimates, forecasting ongoing losses into FY17/18, with below consensus estimates. CS describes the market as being “oversupplied”. Regarding the recently grounded H225’s, CS notes that “we could see a scenario where demand from the O&G business for the H225 never returns to its previous level”.

But in order to justify not moving to a sell recommendation, CS describes Bristow as being “net short” the Naira but sees virtually no impact on the income statement. The implosion of the British Pound was not even addressed.

In the same report, CS discloses that 90% of its recommendations are for Buy or Hold, while only 10% of its global ratings are listed as “Sell”.

From current prices, CS sees just 12% upside in the share price.

Conclusion

There are so many problems with Bristow that it is difficult to know where to start. However, I can safely say that I expect a steep plunge to $6-8 following new “surprise” disclosures on the upcoming conference call.

Further declines and ultimate bankruptcy risk are harder to handicap. But as with Erickson and CHC, there could be significantly greater downside over the next 9-12 months.

What investors DO KNOW is this:

Bristow’s shares have already declined by 80% over the past year, as its financial condition has deteriorated drastically. Cash balance has fallen. The dividend has been cut by 80% (so far). Revenues continue to drop and losses continue to mount. Multiple competitors have recently gone bankrupt and are now flooding the market with unused helicopters and underpriced competition. This heavily affects Bristow’s asset values as well as its revenue and income (losses).

Management and board members are resigning, and management specifically recruited a replacement board member with notable experience in bankruptcy

Bristow is sitting on over $1.1 billion in debt, and was forced to renegotiate debt covenants in May. At the time, the banks were most likely encouraged by a recent doubling of the price of oil off of its February lows, from $25 to over $50. However, its credit rating has already been downgraded to Ba3.

But with subsequent developments the banks are now likely sweating bullets.

What investors DO NOT KNOW is this:

There have been major negative developments for Bristow, many occurring in jut the past few weeks. Investors are totally in the dark.

Very shortly AFTER the new covenants were agreed, Bristow was hit hard by the 15% fall in the pound and the massive 40% drop in the Nigerian Naira. (At the same time, oil fell by 10-15% from its February highs.)

These huge impacts are the result of huge massive unhedged currency exposures.

Despite having tremendous exposures to various global currencies, Bristow does NOT engage in financial hedging.

As recently as May, management was saying that it had zero exposure to any move in the British Pound. Yet we are now finding out (just a few weeks later, post Brexit) that its real exposure could be in the tens of millions of dollars.

But the bigger surprise will be Nigeria. So far management has said nothing about the 40% drop in the Nigerian Naira, even though previous disclosures would indicate that operating income should plunge by 22% on this alone. African (mostly Nigerian) revenues amounted to $255 million in 2016. However, due to the plunge in the Naira, these revenues are most likely going to disappear due to the simple economics of the depreciated Naira.

(It should be noted that the soon-to-disappear Nigerian revenues are actually larger than all Search and Rescue revenues.)

In addition, we are also likely to hear about significant pressure being placed on asset values, revenues, profits (losses) and margins as a result of CHC filing for bankruptcy in May. CHC is now operating at a distinct advantage to Bristow. It can undercut Bristow on price and is flooding the market with unused helicopters.

The SEC inquiry

The full impact of the past SEC inquiries has yet to be determined. But there is no good outcome that can be expected from it. The SEC was specifically asking about Bristow’s use of offshore tax havens to protect nearly 50% of its pre-tax income from US taxes. Prior to completing a response to the SEC, the then-CFO resigned despite having no new employment lined up. Bristow then oddly replaced him with an M&A executive whose past experience was in working for and advising Enron for decades.

The impact of an SEC action (if any) could affect both current and future financials by eliminating offshore tax advantages for Bristow. This problem could arise at the division level, even when the parent is losing money for the time being. This would simply make ongoing losses even larger. Even worse, an SEC action (if any) could potentially result in the payment of back taxes owed, at a time when Bristow can least afford it.

As we clearly saw with MDC Partners, the conclusion of a detailed dialogue with the SEC is by no means an “all clear”. Following the similar conclusion of its dialogue, MDC disclosed an SEC subpoena. Its stock fell 33% and the CEO was forced to resign.

The catalyst for a 40-50% drop in the share price is the upcoming earnings call, with a number of new “surprise” disclosures.

Management has made its predicament far worse by repeatedly hitting investors with unexpected surprises, resulting in much larger losses than were originally expected.

Management repeatedly tries to focus investors attention on any minor positive development, while attempting to downplay major negative events. But in each case, the truth comes out at the end of each quarter.

In each of the past 3 earnings calls, we have seen the share price quickly drop by at least 20-30%.

We have seen nearly identical situations before with helicopter operator Erickson Air Crane, and we saw it before with direct competitor CHC Helicopter. Both of these companies were originally trading in the $20’s.

As they declined by more than 50% to the single digits, “value hunters” thought they could time the bottom in the stock. In each case they appeared to be “too cheap to ignore”. But with declining fundamentals and a heavy debt load, there simply was not bottom to be found. Both Erickson and CHC now trade for just pennies on the dollar.

The sell side research on Bristow is in fact worse than most. The various analysts have continually told investors to Hold or Buy the stock even as it plunges with each and every new earnings report or corporate development. It appears that the majority of the content from these reports consists of near-verbatim quotes from management, expressing their usual relentless optimism, while largely ignoring points of obvious concern. As is often the case, the majority of sell side analysts happen to have been involved as Bristow’s investment bankers and lenders.

Disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in BRS and during the past 12 months has shared his fundamental and/or technical research with investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied